Digressions&Impressions

The Euro Survival Explained By One Graph (which also helps explain why the crisis will not be resolved)

Source: Eurocrisis Monitor.

The graph shows the balances of the Eurozone National Central Banks (NCBs) with the European Central Bank (ECBs). According to the Monitor it is "a key indicator of Europe's balance of payments crisis and continues to be a biomarker of financial stability in the Euro area."* As the Financial Times explains, "Target2 is the real-time gross settlement (RTGS) system owned and operated by the eurosystem. Target stands for trans-European automated real-time gross settlement express transfer system....It acts to balance out payment shortfalls and surpluses throughout the system, by transferring funds between respective national central banks as and when needed." The methodological back story is interesting because the indicator was initially invisible to policymakers because (a) the ECB did not keep track of these numbers (it started publishing the numbers only at the end of October 2015), in part, (b) because on its balance sheet they net out to zero. Originally the indicator was put together from NCB balance sheets.  (The back story can be found in this article.) What the graph shows is that the German central bank has accumulated a huge surplus (at the height of the crisis this was also true of the Netherlands), while Greece (and a few other Mediterranean countries) has a huge deficit.** These figures dwarf (by a factor 10) the 'headline' numbers that have been the focus of the bail-out negotations (and which have suggested that the crisis is quite manageable).  I return to the mechanisms behind this at the end of this post.

If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem. J. Paul Getty

If the Greeks had been pushed out the Euro, Germany (as the largest creditor and also the largest shareholder of the ECB) would have to swallow a serious loss. To give you a sense of the magnitude: it would have added about a quarter to a third to the German national debt. This puts a different light on the 'negotiations' of the last few years. At some point the Greeks recognized that they had entered a situation of mutually assured destruction: if they get pushed out or unilaterally leave the Euro, they and the Germans suffer mightily. The Greeks, who would devalue at once (amidst a liquidity crisis and capital flight), would suffer another huge fall in living standards (even the Icelandic experience suggests a serious decline and few more years of pain), while the Germans would have non-trivial further debt (and eventually higher taxes and/or inflation) and further turmoil in the Southern frontier of Euroland (with all eyes on Italy). So, in that light more European integration with more attempts at convergence and more support for Greece (however reluctantly and ungenerously) is the path of least resistance. Undoubtedly among some German decision-makers there is a residue of pro-European feeling and a reluctance to be blamed for break-up of the Euro (and accompanying uncertainty), but the underlying facts forced their hands (and shows how silly the public spectacle of purported French solidarity and German strictness really was).

As I noted above the graph also explains why the euro-crisis won't go away. One way to understand the graph -- and this how Sinn and Wollmershaeuser present it in their classic paper (I am about to simplify, of course) -- is that the numbers of the deficit countries (so called GRIIPS: Greece, Italy, Ireland, Portugal, Spain) represent a mixture of capital flight and printing money (or monetary easing) facilitated by the ECBs willingness to accept lousy collateral from countries in the midst and aftermath of banking crises (especially Ireland, Spain) and fiscal crises (especially Greece, and Italy). This is not false, but the narrative obscures that the graph also represents (sadly Sinn & Wollmershaeuser are silently on this) the inevitable outcome pattern of Germany's under-consumption/thriftiness, that is to say, Mercantile (export oriented) policies. To put the point in historical perspective: within the Eurozone this is a classic balance of payment crises familiar both from the recurring crises under the gold standard and, more recently, the collapse of the Bretton Woods system (the latter also involved huge German current account surpluses). For the time being, Germany is not changing its mercantile stance, and the ECB is letting GRIIPS (and possibly France) print money to deflate their economies.

What the graph also illustrates is that the north American economists who warned that the creation of the Euro was a "gamble" (e.g., Eichengreen) from the perspective of optimal currency area theory were right. If we treat 2007-9 as an external shock, we discern in the data the effects of a huge asymmetric response to it. All other things being equal, without German willingness to keep sending income transfers to Greek citizens, the Euro will keep limping from crisis to crisis. (This should not be confused with the ongoing European banking crisis which represents the political unwillingness to restructure and or close a huge number of Zombie banks and concerns about the real world economic impact of de-leveraging. ) German exporters benefit from the Eurocrisis because it keeps the Euro lower than it would be outside the Eurozone. Until the majority of the German taxpayers and consumers pull the plug on this arrangement, we should expect lots of crisis-summits and exceptional, "one last, very strict" bailouts.* Muddling through may well be the least worst option.

 

Why is the IMF Protecting Central Bankers?

Macroprudential policy is a complement to microprudential policy and it interacts with other types of public policy that have an impact on systemic financial stability. Indeed, prudential regulation, as carried out in the past, also had some macroprudential aspects, and the recent crisis has reinforced this focus; hence, a clear separation between “micro” and “macro” prudential, if useful conceptually, is difficult to delineate in practice. Moreover, no matter how different policy mandates are structured, financial stability tends to be a common responsibility, reflecting the far reaching consequences of financial crises. This calls for coordination across policies, to ensure that systemic risk is comprehensively addressed. Equally important, macroprudential policy is no substitute for sound policies more broadly, including, in particular, strong prudential regulation and supervision, and sound macroeconomic policies. Operational independence in other policy areas, including monetary and microprudential policy, should not be undermined in the name of macroprudential policy.

To be effective, institutional arrangements for macroprudential policy need to ensure a policymaker’s ability and willingness to act—including clear mandates; control over macroprudential instruments that are commensurate with those mandates; arrangements that safeguard operational independence; and provisions to ensure accountability, supported by transparency and clear communication of decisions and decision-making processes.--INTERNATIONAL MONETARY FUND (2011) "Macroprudential Policy: An Organizing Framework [Emphasis added.--ES]

After the stagflation of the 1970s, the conventional wisdom in the 1980/90s trough the turn of the century was that central banks should be made as independent as possible from political control; this conventional wisdom was translated in high degree of operational independence in most advanced economies (see here for useful distinctions and history). Let's stipulate, for the sake of argument, that if keeping inflation low is the only/main monetary policy objective that such independence makes sense and is supported by sound empirical evidence. Even so, the two decade experiment with central bank independence has to be judged a failure, and it is distressing that the IMF is unwilling to discuss the issues frankly.

For, as the most recent financial crisis reminded us, Central Bankers have more roles than fighting inflation. They have considerable responsibility for the health of the financial system as a whole (now known as systemic risk), and they bear some non-trivial responsibility for preventing financial bubbles*--the clean-up of which is not just very expensive and painful to the economy, but also has non-trivial distributive consequences. While there is plenty of blame to go around, central banks failed to take the punchbowl away when they could; as recounted before, there was considerable cognitive regulatory capture, reliance on outdated models  (which treated mortgages as safe--this mistake was especially clear in the public utterances by the Dutch central bank director, Wellink), and a permissive attitude (enshrined in Basle agreements) toward banks' internal risk modeling (the list is longer). This is not to deny that (a) some central banks acted prudently in the run-up to the great recession [Canada's has been widely praised], and (b) some central banks performed well in the eye of the storm (in my non-expert view Bernanke did so).

Now, one may claim that politically controlled central banks would have performed just as badly. This is by no means obvious. For, while it's clear (let's stipulate) that politicians are sometimes permissive of inflation in order to nudge employment along, even this is not a universal rule given the political clout of pensioners and other people on fixed incomes not to mention creditors, all of whom dislike inflation intensely. Moreover, it is by no means obvious that they would want to risk being held responsible (even retrospectively) for the gigantic financial bail outs we have witnessed. Even if some politicians would have behaved no differently than the central bankers did, it is extremely unlikely, given the varied political conditions and coalitions in different countries/continents, that they would have acted so uniformly mistakenly as the central bankers have done. I am not claiming that politicans always get it right, but the fact of the matter is, when the central bankers screw up, as they did, the central bankers don't pay for their mistakes; it's the taxpayers that do--that is to say, the incentives are, in fact, aligned incorrectly to sustain central bank independence.

It says something of the mistrust of politicians among the intellectual, economic, and financial elite(s) that the argument(s) and observations just sketched are not being discussed more widely. (Undoubtedly I have simplified the situation and maybe I have overlooked something important.) In fact, the IMF report quoted above -- which is supposed to be a technical report not a political report -- goes out of its way to repeatedly insist, on the basis of no empirical evidence whatsoever,** that central bank independence should be sacrosanct. Obviously, if there were robust knowledge that could guide macroprudential and monetary policy, then, perhaps, one could make an argument that rule-following, public spirited experts should be entrusted with independence. But as the IMF report notes, such knowledge is as of yet unavailable. The big picture decisions of managing the financial system are, in fact, political -- because uncertain and distributive in character -- and should be made by politicians, even if some politicians prefer otherwise (so that they can never be blamed). Either way, it is by no means obvious that keeping central bankers independent promotes "accountability."

 

On Stockmarket and Airplane Crashes

It may fall to the political scientists rather than the economists to give us a complete story of what happened" [during the financial crisis].

To make this contrast more stark, compare the authoritative and conclusive accident reports of the National Transportation Safety Board (NTSB)—which investigates and documents the who–what–when–where–and–why of every single plane crash—with the twenty-one separate and sometimes inconsistent accounts of the financial crisis we’ve just reviewed (and more books are surely forthcoming). Why is there such a difference? The answer is simple: complexity and human behavior.
While airplanes often crash because of human behavior or “pilot error,” the causes of such accidents can usually be accurately and definitively determined with sufficient investigatory resources. Typically there are a small number of human actors involved—the pilots, an air traffic controller, and perhaps some maintenance crew. Also, the nature of accidents in this domain is fairly tightly constrained: an airplane loses aerodynamic lift and falls to the ground. While there may be many underlying reasons for such an outcome, investigators often have a pretty clear idea of where to look. In other words, we have sufficiently precise models for how airplanes fly so that we can almost always determine the specific causal factors for their failure through relatively linear chains of physical investigation and logical deduction. Human behavior is just one part of that chain, and thanks to flight data recorders and the relatively narrow set of operations that piloting an aircraft involves—for example, the pilot must lower the landing gear before the plane can land, and there’s only one way to lower it—the complexity of the human/machine interface isn’t beyond the collective intellectual horsepower of the NTSB’s teams of expert investigators.
Now compare this highly structured context with piloting an investment bank, where the “instrument panel” is the steady stream of news reports, market data, internal memos, emails, text messages, and vague impressions that a CEO is bombarded with almost 24/7, not all of which is true; where the “flight controls” are often human subordinates, not mechanical devices or electronic switches; and where there is no single “flight data recorder,” but rather hundreds of distinct narratives from various stakeholders with different motivations and intentions, generating both fact and fantasy. If we want to determine whether or not the failure of Lehman Brothers was due to “pilot error,” like the NTSB, we need to reconstruct the exact state of Lehman prior to the accident, deduce the state of mind of all the executives involved at the time, determine which errors of commission and omission they made, and rule out all but one of the many possible explanations of the realized course of events.
Given that we can’t even agree on a set of facts surrounding the financial crisis, nor do we fully understand what the “correct” operation of a financial institution ought to be in every circumstance, the challenges facing economists are far greater than those faced by the NTSB. However, the stakes are also far higher, as we’ve witnessed over the past four years. There is a great deal to be learned from the NTSB’s methods and enviable track record, as Fielding, Lo, and Yang (2011) illustrate in their case study of this remarkable organization. And one of the most basic elements of their success is starting with a single set of incontrovertible facts. In other words, we need the equivalent of the “black box” flight data recorder for the financial industry, otherwise we may never get to the bottom of any serious financial accident.--Andrew W. Lo (2012) Journal Economic Literature.

The passages quoted above come from a widely read, wonderful, extended survey of books by economists and journals on the financial crisis. Andrew Lo (MIT) is co-author of one of the most important and influential papers in the history of analysis of stock-markets (which denies that markets behave as a random walk--a key feature of the efficient market hypothesis [recall and here]). It has over 7000 citations. Oddly enough, his most important paper, "The National Transportation Safety Board: A Model for Systemic Risk Management" has only 17 citations. (This tells us the market for ideas in financial economics is not efficient.) Odder yet, when he draws on his own research in the passage quoted from his 2012 review article, he draws extremely incomplete lessons from his very own research. Let me explain.

I first encountered the idea of a financial cockpit when I met Jean-Pierre Fouque in Santa Barbara (whose office was right down the hall when I was visiting the philosophy department). The idea is deceptively simple: make sure that key policy-makers (at central banks and other oversight agencies) have real-time access to relevant data to monitor systemic risk in the market. As Lo notes (note 23 attached to the quoted passage) something like this was "behind the Dodd Frank Act's creation of the Office of Financial Research." (See also David Warsh's account of Lo's 2008 testimony to Congress). The guidelines of the (more international) Financial Stability Board, also tacitly rely on bank regulators having access to relevant data in real time so that they can regulate and monitor, say, shadow banking entities.

A moment's reflection makes clear that even in airplanes nobody (inside or outside a cockpit) has access to the relevant data before or during a crash. A further moment's reflection reminds us that lots of participants in markets have incentives to (a) hide their data, or (b) generate dummy data to gain a competitive advantage (and they would surely not trust the probity of the regulators to never abuse the data for public or private gain). Moreover, and this is a point that Lo and his co-authors make in his overlooked piece on the NTSB, there is (with exception of outside lawyers) nobody that benefits from airplane crashes, whereas in trades gone sour there may well be counterparts that gain (and there are examples of folk who made a killing during the crash). Not to mention the fact, that nobody really knows what data should or should not be included in that financial cockpit; as Lo's review reminds us, we simply don't understand what happened yet, and so don't have reliable models to tell us what data is salient. As we know from nuclear power station disasters [many of which involve mistakes in reading the data in the control room], and other complex systems failures, including airplanes (recall), a complex system in which monitoring of the health of the system is not part of the normal functioning of the most important (and well trained, if not drilled) actors within the system, is fundamentally unstable.

So, even if we do figure out what happened during 2007-9, odds are that during the next crisis systemic risk will be generated, in part, by products that are not invented yet by people who do not feel it's their job to care for the system. There is an important policy lesson here: all approaches that count on regulators of complex systems (as the financial market) to have access to and know how to act on data during a crisis, are not robust. To be sure, regulators don't fly entirely in the dark and don't only make bad decisions: the Treasury Department's guarantee of money market funds almost certainly prevented a total meltdown of the financial system in 2008 (recall).

This is not to deny the significance of having high quality data which may be useful to reconstruct what happened (as Lo suggests, and this may have been all he intended to suggest) after the fact. But such a post-facto perspective misses some of the key features of air-travel success: (i) the ongoing drilling and training of pilots, air-controllers, and others that are part of the system; (ii) the extensive and expensive stress testing of planes and components before commercial flight--in the JEL article, Lo misleadingly suggests that we really know how planes fly; as I learned from George Smith (a failure expert) that's true at a high level of generality, but despite cheap and massive computer power, in practice we are constantly dealing with extremely subtle approximations;* (iii) the ongoing feedback loop between design, practice (including minor failures), investigation, and regulation. Moreover (and now drawing on Lo's research on NTSB): (iv) at NTSB the separation of the regulation and investigation functions -- this is a key feature identified by Lo and his colleagues. That is, the "paradox of less regulatory authority yielding greater influence is one of the most striking characteristics of the NTSB;" (v) at NTSB there is a culture of open-ness and "inclusive atmosphere for all stakeholders involved" (again quoting Lo et al). Most astonishingly of all, (vi) "Each of the [NTSB's] board members and employees undergoes a rigorous ethical review process and is subject to ongoing restrictions such as not having any financial interests in transportation-related companies so as to minimize actual and potential conflicts." (Section 2.3 makes for interesting reading for those of us who note that economists and financial regulators routinely act as if financial incentives do not apply to them!) And, not trivially, (vii) work at NTSB is a capstone not a steppingstone to future careers which contrasts between the revolving door we encounter between Wall Street, Central Banks, Academia, and Politics. It is disconcerting that when Lo writes for a wide audience of fellow economists in JEL,** he does not challenge them to reflect on his best insights.

 

 

Adam Smith (and Buffon) on Abstraction and the measure of metaphysical-ness (or complexity)

The man who first distinguished a particular object by the epithet of green, must have observed other objects that were not green, from which he meant to separate it by this appellation. The institution of this name, therefore, supposes comparison. It likewise supposes some degree of abstraction. The person who first invented this appellation must have distinguished the quality from the object to which it belonged, and must have conceived the object as capable of subsisting without the quality. The invention, therefore, even of the simplest nouns adjective, must have required more metaphysics than we are apt to be aware of. The different mental operations, of arrangement or classing, of comparison, and of abstraction, must all have been employed, before even the names of the different colours, the least metaphysical of all nouns adjective, could be instituted.--Adam Smith (1767) Dissertation on the Origin of Languages

The Dissertation on the Origin of Languages (hereafter Languages) was added to the third edition of The Theory of Moral Sentiments (TMS). In Languages Smith develops an account in which language and mind co-develop. The argument unfolds slowly in Smith’s hands, and the passage quoted above is excerpted from a much longer argument.

The very possibility of applying what Smith calls a “noun adjective,” presupposes having the capacity for contrastive reasoning and a mental capacity for classification and conceptualization of, as well as abstraction from, these experiences. On Smith’s view objects must be conceived to be bearers of properties before adjectives can be applied to features of these objects. Moreover, in the quote Smith clearly conceives of nouns adjective with different degrees of ‘metaphysical--ness’--presumably here meant in terms of abstraction from the appearances. Abstraction turns out to be the key variable when Smith turns to prepositions: “The invention of such a word, therefore, must have required a considerable degree of abstraction… Whatever were the difficulties, therefore, which embarrassed the first invention of nouns adjective, the same, and many more, must have embarrassed that of prepositions,” (Languages).

Abstraction is a mental power. For example, traditionally, geometric properties were understood as abstracted from sensible qualities. This conception of abstraction involves a kind of subtraction or stripping away from sensory input (where one focuses on only some elements and throws away the rest). So, for example, when the French natural historian, Buffon, describes the application of geometry to nature, he writes, “it is necessary that the phenomena we are concerned with explaining be susceptible to being considered in an abstract manner and that their nature be stripped of almost all physical qualities. For mathematics is inapplicable to the extent that subjects are not simple abstractions.” (“Initial Discourse” Histoire naturelle [recall];* Smith refers to Buffon in his Letter to Edinburgh Review). Sometimes also Smith uses “abstraction” in this sense (recall here for more discussion).

But that's not Smith’s way of understanding abstraction in Languages. There, for Smith, a thought is more abstract than another thought when it requires more discrete mental “operations,” or steps, to introduce during the history of human development. So, in addition to being a mental power, abstraction is itself a kind of measure for metaphysical-ness. A thought is very abstract if starting with sensations, as a kind of baseline, it requires many further mental operations to be thought. That can include the traditional kind of abstraction, of course (if the stripping of qualities is done in careful order), but also many other kinds. So, Smith’s general picture of mind is that it is akin to a kind of machine capable of different, countable and sequential operations. Smith borrows the idea of mental operations from Hume (see, especially, Treatise 1.3.8.15, where Hume also notes “’tis very difficult to talk of the operations of the mind with perfect propriety and exactness,”) but not the treatment of metaphysical-ness.” It's a neat idea and anticipates the development of measures of complexity.

Unfortunately, Smith does not explain some of the tacit commitments he relies on here. So, for example, he seems to assume a kind of natural minimal, unit for each mental operation. He also seems to presuppose a kind of mental-least-action-principle such that in the course of human development we naturally find -- or we can rationally reconstruct post-facto -- the least required mental operations in each step of abstraction. Finally, as Steven Horst pointed out to me, it is also unclear if for Smith the degree of abstraction is ultimately dependent on empirical facts about human cognitive architecture or the logical (ahh) complexity of the represented content.

RIP: Nathan Rosenberg 1927-2015

Yesterday, I learned from his former colleague, June Flanders, that the Stanford economist, Nathan Rosenberg, has died. At his passing he was the Fairleigh S. Dickinson, Jr. Professor Emeritus of Public Policy in the Department of Economics. He was an expert in the economics of technology, especially technological change and his work influenced theories about the role of institutions and technological change in economic history  and innovation studies (see, e.g., North's Nobel lecture). Some other time I hope to return to his significance in these areas for philosophy of science and science policy.

Not unlike other economists of his generation, Rosenberg was educated in the history of economics and not above making genuine contributions to scholarship in the area and to integrate such scholarship in his contributions to economics. His papers in the area (the most important of which published during the 1960s in leading journals) were collected in The Emergence of Economic Ideas: Essays in the History of Economics (1994). 

I never met Professor Rosenberg in person, but I had a significant interaction with him. I read his seminal paper (1960) "Some institutional aspects of the Wealth of Nations" (The Journal of Political Economy) while researching my dissertation (recall also this post). Rosenberg's paper was not unknown, but the only full-length study of Smith that had been clearly influenced by it was Jerry Muller's very fine study, Adam Smith in His Time and Ours: Designing the Decent Society (1993); I thought this had not exhuasted Rosenberg's insights. So, the central chapter of my dissertation, an original interpretation of Smith's methodology of the Wealth of Nations (a revised version was published here), was an elaboration of Rosenberg's insights in light of my own reconstruction of Smith's epistemology and philosophy/sociology of science. 

Because even widely read professional philosophers (like the supervisors of my dissertation) were not expected to be fully conversant in scholarship in the history of economics, I approached a bunch of economists to read this chapter (assuming incorrectly at the time, that professional economists would be relevant experts). Rosenberg sent me generous and detailed comments on my chapter (which were gratefully acknowledged) as well as a copy of his own The Emergence of Economic ideas. In particular, his comments helped me formulate my central claim about the nature of natural prices in Wealth of Nations in terms that would be familiar to modern readers. Now that I have a become a busy, over-extended scholar (that routinely fails to meet accepted and self-imposed deadlines), I recognize the true generosity of Rosenberg to draw on his most valuable scholarly resource (his time) in order to read and comment on work by an unknown, junior scholar from a different discipline. Because I was abroad at the time, he also offered to fax me his comments.

Emergence also reprints Rosenberg's elegant paper on Mandeville. This paper was published before Hayek's (more) famous lecture on Mandeville and it clearly anticipates several of Hayek's most important claims (as Hayek acknowledges). When I first read it (after Rosenberg had sent me Emergence), it was a total eye-opener on the significance of Mandeville (on Hume and Smith).

I close with a scholarly observation. In going through my correspondence with him, I noticed that I wrote a letter with my responses to each of the paper's of Emergence. (I hope this amused him!) I quote one of these comments (from December 10, 2001) to give a flavor of his significance to Smith scholarship: "Reading your paper on "Adam Smith, Consumer Tastes, and Economic Growth," finally made me see why Smith devotes so little systematic attention to the service-sector in commercial societies. (Something that has vexed me, as I found the obvious answer, services are not that important in his day, unsatisfying.) He had identified services with the backward (and retrogressive stage of) Feudalism in which there were few opportunities for economic growth (p. 368 & 372)."

 

Wisdom in economics...Keynes, Savage, and Friedman

The maximization of such an expected value may also be regarded as a maxim for behavior. As such, it promises to have important implications for statistical theory. Cf. L. J. Savage, "The Theory of Statistical Decision," Journal of the American Statistical Association, XLVI (March, 1951), 55-67. Success of the maxim in this domain, as in any other area of decisions involving uncertainty, depends, not on its empirical verification for the economic behavior of men at large, but on its acceptability, to individuals who are particularly concerned with such decisions, as a rule guiding "wise" behavior in the face of uncertainty.--Milton Friedman & L. J. Savage (1952) The Expected-Utility Hypothesis and the Measurability of Utility (463).

Yesterday, at a workshop I co-hosted with Rogier de Langhe in Ghent, David Teira called attention to the quoted passage in a  paper (co-authored with Rasmus Winther) he presented. The passage occurs in the first substantial footnote of the Friedman/Savage paper (which by building on work by Von Neaumann & Morgernstern, together with their earlier 1948 paper, generated the canonical treatment of the axioms of expected utility theory).* Hereafter I will call their joint 1952 paper: 'F&S1952.' Teira astutely noted that the quote puts a normative ("wise") interpretation on expected utility theory. This is surprising because standard historiography suggests that the normative interpretation was a much later consequence, the result of criticism (see, for example, this fine paper by Hands.) In fact, the standard story can base itself on F&S1952:

Two quite different classes of objections are made to this particular convention for assigning a "measure" to utility:... (2) that any convention that would treat utility as measurable is undesirable or unnecessary... The second objection, on the other hand, cannot be accepted. It would deny economics a mode of speaking and expressing theories that has been found useful if not indispensable in other sciences. It expresses a viewpoint that its proponents would find impossible to apply consistently; they would have to deny themselves the privilege of speaking of money income, or stock of money, or size of population as measurable. If this viewpoint seems persuasive for utility, it is, we think, partly because some hypotheses that would, if verified, have implied convenient measures of utility were actually flagrantly contradicted by experience, and partly because of a widespread confusion between positive economics and normative economics, a widespread tendency to use the same word---utility- to stand for two quite different things: on the one hand, a quantity that it is useful to regard an individual as maximizing in interpreting his behavior and predicting his reactions to changed circumstances, and, on the other hand, a quantity that he "should" maximize or that society "should" maximize or help him maximize. The identification of these two conceptually different magnitudes is a maxim for wise behavior or an ethical precept, not a scientific proposition, and is in no way required by the adoption of a particular convention for "measuring" utility. (474)

This is the closing paragraph of F&S1952. Here wise behavior is in the domain of normative not positive (or empirical/scientific) economics. As is well known, for Friedman the distinction between normative and positive economics is central to his methodology of economics (which he was working on at the time and which he published in 1953). And, his ''as if" methodoloy is fully present in the first sentence of F&S1952: "individuals choose in such circumstances as if they were seeking to maximize the expected value of some quantity." Now, Teira offered an interesting explanation for the presence of a normative conception in F&S1952, and here I don't want to steal his thunder.

Before I get to what I take to be the significance of the footnote, I should note that, I think the footnote reflects the influence of Savage. For three reasons: (i) it fits uneasily with Friedman's larger methodology at the time; (ii) in the note they explicitly appeal to Savage's work, and (iii) Savage thought that one could treat uncertainty as a species of risk: one treated the probabilities as subjective (see his Foundations of Satistics), although Savage was quick to note that “we must be prepared to find reasoning inadequate to bring about complete agreement.” (1954 [1972]:7; see also 3, 67ff.) So, Savage did not endorse the ideal that there could be full consensus about wisdom. By claiming that this line of thought reflects Savage's influence, I do not mean to deny the significance of it to Friedman's thinking.

For, the idea that wisdom in the face of genuine uncertainty could still be a species of (mathematical) rule-following is an important rupture with earlier modes of thought which understood wisdom in terms of judgment. For example, at the hight of the financial crisis, Keynes had argued, reflecting widely held belief, that in the face of genuine (computational) complexity, that is uncertainty, central bankers should be given considerable "discretionary power" (to manage its reserves): he denied that “the rules of wise behavior by a central bank could be conveniently laid down -- having regard to the immense complexity of its problems and their varying character and varying circumstances." (Quoted from Bibow.) Of course, Keynes insisted that the discretionary power should not be absolute; as Bibow notes, Keynes thought that the economic and moral aims of the central bankers should be set by government.

Friedman, by contrast, in reflecting on the experience of monetary policy during the financial crisis in his great work with Anna Schwartz came to think that much of monetary policy ought to be rule-based (see, for example, here, and here). Whether we think of these rules as robust heuristics (to be ignored in some future emergencies) or as a species of optimizing rationality is a further question that lay in the future. Sadly, whether it's wise to think of wise behavior in conditions of uncertainty as an instance of utility maximization was not debated in full when introduced into the literature, perhaps because it was treated as pertaining to 'individuals' (who are free to do what they wish) rather than social institutions; or, perhaps because sometimes footnotes fly under the radar screen.

 

Five Comments on Jonathan Wolff's List of Five Books

The eminent political philosopher Jonathan Wolff is interviewed here. [HT Jacob Levy; Jason Stanley.] After an autobiographical introduction he is invited to discuss five books "by thinkers who have shaped the field." Wolff mentions Hobbes's Leviathan, Marx's Early Writings, Rawls's A Theory of Justice, Nozick's Anarchy, State, and Utopia, and Cohen's If You’re an Egalitarian, How Come You’re So Rich? The interview is a lovely mixture of autobiography, biography (especially of Cohen), and enthusiasm for the issues. I thought it was especially good on what makes Nozick's Anarchy so memorable. Even so, I offer critical observations because Wolff's comments reveal non-trivial systematic problems with political philosophy (as practiced by some of the very best in the field).

1. In discussing Leviathan, Wolff exhibits an absurd pride in not having really read parts 3-4. This is connected to a remarkable oversight: the lack of mention of religion (and political theology) as a key/central issue for Hobbes's project. (Leviathan is oddly relevant!) I am not picking on his lack of scholarly literacy or his lack of shame -- so common among certain kind of analytical philosophers of his generation, including the silly idea that Hobbes "is an analytical philosopher," [it's silly because Hobbes takes rhetoric very seriously whereas analytical philosophers, a few noble ones excepted, tend not to]* -- in not having read fully a book he discusses at length (not exactly the model of virtue in a Dean of Humanities)! Rather, it reveals how narrow his conception of political philosophy really is and almost certainly reveals a tacit commitment, once popular, to the idea that religion is a thing of the past. I am not saying that one should only focus on religion within political philosophy, but the more modern books mentioned (by Rawls, Nozick, Cohen) that 'shaped' the field are not very profound on the challenges and opportunities posed by religion to political philosophy.  This lacuna -- and it is a considerable given the events of, say, the last thirty years --, suggests something has gone very wrong in the field. [This is not to deny that "Rawls took religion very seriously," but in Wolff's hands Rawls's significance is explicitly not on political theology.]
2. Wolff is reported as saying (while commenting on Leviathan's famous cover) "I can’t think of another political philosopher who’s chosen an illustration themselves for their position." I found this an odd lapse in his memory because several of JJ Rousseau's books have (complex) illustrutations/engravings  as book covers that comment or even guide the reader's interpretations and are mentioned in the text (see here [see also this paper on the Emile [HT Michael Kochin]).
3. Wolff writes about Marx: "Marx finds, in the Wealth of Nations, a whole range of criticisms of capitalism that sound just like Marx. So, for example, Adam Smith argues that the natural rate of wages is the minimum wage — what it costs to keep the worker and his family alive for the day." I think Wolff misremembers his Marx here (and confuses some key concepts in Smith). To be clear it's true that Smith anticipates much of Marx's criticisms of capitalism (see this excellent book by Spencer Pack). But it is not true that for Smith the natural rate is (generally) the minimum wage nor does Marx say this (I am not a Marx expert, so maybe he says it somewhere); rather for Smith wages will only fall to subsistence wages if there is little economic/production growth alongside population growth--something that Marx recognizes (but Wolff not). By contrast, the natural rate is the counterfactual price of a good absent barriers to trade in factors--something that Marx recognizes (and Wolff not). For Smith this price is not a subsistence wage, but rather one that prevails when there is no famine. Marx understands this about Smith, but disagrees; he argues that within an extensive division of labor the worker lacks the bargaining power to (a) benefit from when the market prices are above the natural price (something extremely common) because (b) the capitalist can redirect capital far more easily than the worker can. (Both (a-b) are compatible with Smith's analysis, by the way.) Moreover, Marx thinks that (c) wages are very sticky. (This is not really Smith's position.) Where Marx and Smith differ in Marx's analysis is (to simplify) that Smith thinks wages can be kept above subsistence rates during times of economic growth whereas Marx thinks this is rarely the case (and even if it can be done only at the expensive of the worker relative to capital interests).
4. On reading Rawls Theory of Justice. "You can read a page and not think very much of it and then ten years later come back to it, having thought about the issue yourself, and see Rawls has completely understood the issue, set out all the possibilities, and shown why only one of them is right." I think this is almost right, but it also misses a key feature of Rawls. For, Rawls does not explicitly set out all the possibilities, although he has undoubtedly discerned all of them. He sets out important possibilities and these turn out to have set the agenda for subsequent readers. But to recognize that he is aware he does not set out all the possibities you have to read Rawls's footnotes. For a notable example, see p. 314 n 16 of TJ. In the note Rawls cites both Arrow and Knight, focusing on their (limited) agreement and ignoring the deeper disagreement. As Rawls adds (in his own footnote): “in both cases see the footnotes!” That is to say, Rawls knows the possibility space is broader than he presents and he allows the diligent reader to recover that. (I leave aside here what purpose this may serve.)
5. Finally, It is striking that Wolff mentions no women, no non-white person, and no pre-early modern person. Perhaps, he is right sociologically that "the three leading political philosophers of the contemporary era are Rawls, Nozick, and Cohen," but that is really an artifact of the cold war. I love Hobbes and Rawls, but if we think of issues that ought to dominate political philosophy (religion, gender equality, global and racial injustices, mass human extinction, toleration, technology, military-prison industrial complex, ideology, etc.), I can think of more important political philosophers (in the contemporary era, say, MacKinnon, Fanon, Arendt, Foucault),+ not the least of which are Plato (and Aristotle) or Al-Farabi.

The Technocratic Conception of Politics (The Economists and Rawls redux)

By a 'technocratic conception of politics,' (recall) I mean to capture the following three features of an enduring image of politics present in (social) science: first, it is characterized by the ideal that with social knowledge and its progress, substantial political disagreement can be eliminated. Here is a very striking instance of the claim from Milton Friedman's (1976) Nobel lecture: "Many countries around the world are today experiencing socially destructive inflation, abnormally high unemployment, misuse of economic resources, and, in some cases, the suppression of human freedom not because evil men deliberately sought to achieve these results, nor because of differences in values among their citizens, but because of erroneous judgments about the consequences of government measures: errors that at least in principle are capable of being corrected by the progress of positive economic science." The context of the passage is the furor surrounding his association with the so-called 'Chicago Boys' in Chile and the assassination of his Chilean critic Orlando Letelier (recall).

In particular, second, this ideal of conflict-free politics presupposes (as is clear from the quoted passage in Friedman's Nobel lecture) considerable value-unanimity in society. So, for example, in a famous article, the Chicago-school economists, Stigler and Becker write, "one may usefully treat tastes as stable over time and similar among people;" establishing this point "is the central task of this essay." When value-unanimity is granted then ordinary welfare economics is possible as a kind of (social) engineering science (recall).

Third, the conception requires an image of science in which one of the central aims of policy scientists is to achieve consensus (or lack of disagreement). In modern economics this idea goes back at least to Sidgwick's (1887) Principles of Political Economy (recall; for some prehistory on Hume). It was a central feature of Lionel Robbins's influential methodological restatement (1932) of what economics is: "Surely, for the sake of securing what agreement we can in a world in which avoidable differences of opinion are all too common, it is worth while carefully delimiting those fields of enquiry where this kind of settlement is possible from those where it is not to be hoped for —it is worth while delimiting the neutral area of science from the more disputable area of moral and political philosophy." This image of science was made widely popular by Thomas Kuhn in Structure (1960), but via Talcott Parsons's Weberianism and others it was already well known in mid-twentieth century social science.

It is worth emphasizing that the expectation of consensus was by no means universal. Friedman's sometime co-author, Savage, insists in The Foundations of Statistics, that "we must be prepared to find reasoning inadequate to bring about complete agreement." (1954 [1972]:7; see also 3, 67ff.) But this view became a minority position (cf. Aumann).

On Ethics & Economics and the Pre-History of Friedman’s ‘as if’

But this, measured by the standard of natural science, is not very far. There are no data for a science of conduct in a sense analogous to natural science. The data of conduct are provisional, shifting, and special to individual, unique situations in so high a degree that generalization is relatively fruitless. For the time being, an individual acts (more or less) as if his conduct were directed to the realization of some end more or less ascertainable, but at best provisional and vague. The person himself is usually aware that it is not really final, not really an "end"; it is only the end of the particular act, and not the ultimate end of that. F.H. Knight (1922) "Ethics and the Economic Interpretation," The Quarterly Journal of Economics, 475.(Emphases in original--ES.)

"[E]conomic hypothesis that under a wide range of circumstances individual firms behave as if they were seeking rationally to maximize their expected returns (generally if misleadingly called "profits")16 and had full knowledge of the data needed to succeed in this attempt; as if, that is, they knew the relevant cost and demand functions, calculated marginal cost and marginal revenue from all actions open to them, and pushed each line of action to the point at which the relevant marginal cost and marginal revenue were equal." Milton Friedman (1953) "The Methodology of Positive Economics" (Emphases in original--ES.)

The distinguished historian of economics, Ross Emmett, called my attention to the 1922 piece by Frank Knight. For, as Emmett notes, in the passage quoted above Knight partially anticipates the central methodological stance made famous by Milton Friedman in his 1953 piece (hereafter F1953). There is a known biographical connection between the two—Knight is what I call 'the Godfather' of Chicago economics because he taught so many future 'Chicago-economists' (and non-Chicago Nobel laureates), including Friedman.

In the quoted passages Knight and Friedman both recognize that the mathematical structure of economics should not be taken as a literal description of what goes on inside the minds of individuals or the decision procedures of economic agents (Friedman talks as much about "firms" as about "businessmen"); they also agree that in real life there is no "full knowledge" of the relevant data. Knight had just published a famous book, Risk, Uncertainty, Profit, in which he had defended the idea that because such relevant data were absent – that is we really live in a world of (unmeasurable) uncertainty -- entrepreneurs could make a profit. Friedman takes a different approach: according to him the as-if strategy is vindicated by the predictions that follow from assuming as-if maximization (etc.); these, Friedman expects, will be good enough (in part because, following a hint of Alchian, he assumes that in markets economic agents that deviate too much from the assumption will not survive).

Knight and Friedman both distinguishing economics from ethics; economics is independent and capable of generating agreement--a realm free from "controversies" (Knight 455; recall this post on Friedman). Before I go into the details of the distinction between ethics and economics (in both), it is worth stressing that Knight's defense of the independence and scientific nature of economics is also extremely deflationary; "it is substantially correct for practical purposes." (462) But Knight goes on to claim that,

"A science of conduct is…possible only if its subject-matter is made abstract to the point of telling us little or nothing about actual behavior. Economics deals with the form of conduct rather than its substance or content. We can say that a man will in general prefer a larger quantity to a smaller (the principal trait of the economic man) because in the statement the term "wealth" has no definite concrete meaning; it is merely an abstract term." (Knight 475; the position is echoed partially by Friedman: "Viewed as a language, [economic] theory has no substantive content; it is a set of tautologies." (F1953, 11; see also 7))

On self-interested economists (Krugman on the Clique)

the question is why starting in the 1970s much of academic macroeconomics was taken over by a school of thought that began by denying any useful role for policies to raise demand in a slump, and eventually coalesced around denial that the demand side of the economy has any role in causing slumps.

I was a grad student and then an assistant professor as this was happening, albeit doing international economics – and international macro went in a different direction, for reasons I’ll get to in a bit. So I have some sense of what was really going on. And while both Wren-Lewis and Waldmann hit on most of the main points, neither I think gets at the important role of personal self-interest. New classical macro was and still is many things – an ideological bludgeon against liberals, a showcase for fancy math, a haven for people who want some kind of intellectual purity in a messy world. But it’s also a self-promoting clique.--Paul Krugman "The New Classical Clique."

It is no surprise that an economist calls attention to the significance of self-interest in human behavior. It is more unusual for a professional economist to highlight the role of self-interest within the political economy of science and then apply this to his own discipline. The move is not unprecedented -- it can be traced back to Mandeville and Adam Smith --, and even in recent times it received a notable expression in the work of Gordon Tullock--not a main-streamer, but certainly a familiar name to many economists. Krugman's analysis is interesting because rather than only focusing on monetary incentives (jobs, consulting gigs, lucrative speaker fees, etc.) he also pays attention to the way "intellectual and ideological foundations" generate a cohesive baseline the promotion of which is both a substantive interest as well as one of the means to help distinguish in-crowd (who get the spoils, including -- this is significant in Krugman's piece -- journal space)/out-crowd (who are denied such spoil). The  in-crowd is a "clique" or an "extremist" "movement" with "leaders," who "turned their backs on empirical evidence" when it went against their views.

Krugman's analysis relies on a distinction between those that act from "pure" --  strictly epistemic ("selfless seekers of truth") "motives" -- as opposed to the (ideological) self-interest of the "clique" Krugman is criticizing. That is to say, Krugman is not fully reflexive here--the  folk that he studies (be they ordinary economic agents in the trade models he works with or the other economists described in the column I am quoting from) have one set of motives, while he stipulates that some, but only some, within the sciences have another set of motives. This is an appealing thought and appeals to the vanity of the scientist-economist-philosopher, especially if she can convince herself she remains pure.

Krugman is self-aware enough  to recognize that he is part of a "counter clique" that has had tremendous  success in landing "country consulting" gigs, but in addition to their self-interest (never named as such), they followed the "international evidence" and they are more "open-minded." One need not have an advanced degree to notice how self-serving his analysis is here. There is also no attempt to look at all the disastrous and sometimes immoral policy-advice emanating from the country consultants he lists; "Rogoff...Draghi...Summers" is not exactly a honor-call of scientific integrity and moral wisdom.

So, what to make of this? It's surprising that Krugman makes no effort to help us think about the institutions of economics that structure, say, access to journal space (I have remarked in passing on the tight-knit of gate-keepers in economics). Nor does Krugman offer the reader any guidance on how we might improve  economics such that it becomes more amenable to right sort of empirical evidence. He does not really see the problem; it's just them, even though Alex Rosenberg and I (recall) have pointed out that he is confused on methodology. (I don't say that lightly.) Anybody that has studied the history of science in any depth will learn how hard it is --- and now I adopt a phrase from my undergraduate guru George  Smith -- to turn data into high quality evidence absent the right sort of background theory (see this article for my more elaborate views) and luck. Krugman makes no effort to educate his audience about the complexities of empirical evidence and how hard it is to establish enduring, policy-relevant truths in economics. It is probably impolite to say that to do so would, perhaps, undermine his short-term self-interest as pontificating expert writing for a broad audience that needs to project self-assurance and convey  mastery over esoteric expert knowledge (preserved by pure truth-seekers), but, if he would apply polity economy to economics he might start an important conversation some day in both the republic of letters as well as the polity he undoubtedly wishes to serve.