New Classical Economics Reminds Me Of Creationism

My study of Economics proceeds. I would by and large say I am pretty discouraged by what I am finding.

Last week I finished reading "Keynes The Return Of The Master" by Robert Skidelsky. (Note: many edits/revisions to this post, it still misses much of what it could have communicated, but it's getting old and needs to ship.) Skidelsky is considered one of the greatest living Keynes scholars, having written a 3 volume autobiography. He is also a coauthor of "How Much Is Enough: Money And The Good Life" which I greatly enjoyed and harvested much wisdom from and posted about here.

So this book reviews (New) Keynesian vs (New) Classical economic theory, and then explores how Keynesian ideas could have helped prevent the Great Recession, and could help get us out of the Great Recession.

Classical economic theory is pretty scary. It still adheres to the 18th century principles of Adam Smith: that free unregulated markets will always be the best economic system. So we should all trust "the invisible hand" to make everything work out in the long run.

It reminds me of Creationism because it is not a science that gathers data, creates and tests hypotheses, and graduates the successful ones to theories. Just as Creationism starts with the answer -- god created everything -- and then seeks to filter and warp data to get to that answer, classical economics also starts with the answer -- free, unregulated markets are the best -- and works backwards from there.

The framework this creates is, well, bizarre. Or to quote Skidelsky, "To the non-economist they will seem mad". Economics is basically about equilibriums, particularly between supply and demand. To that we add:

• the rational expectations hypothesis (REH). This says that all the agents in a market -- buyers, sellers, workers -- will always act rationally to further their own best interests. This implies things such as, workers will immediately be willing to work for less as soon as they see that the demand for their labor is dimished. Yeah, right. It also implies that all the agents have perfect knowledge of everything. It has as a cousin the "wisdom of the crowd" thinking we now see re the Internet.
  
• real business cycle theory (RBC). Originally Classical economics denied that there should ever be boom or busts. It added the idea of business cycles where something changes, like oil prices, regulations, or weather, or a new invention comes out, creating a shock to the system, with a boom or a bust until the system regains equilibrium.
  
• the efficient market theory (EMT). This says that "shares are always fairly priced" -- again ignoring partial information and time lags. Risk management models are based on this, and are modeled with Gaussian bell curves -- which ignore the possibility of "Black Swans" -- events 10 or 20 sigma (standard deviations) off of the bell curve mean.
  
• Say's Law which says that "the supply creates its own demand". I guess this implies "marketing is king".
  
• the Arrow Debreu model assumes "that all trade takes at one unique point. ... Time only featured in the form of 'futures markets'". This seems like a very elegant simplification to make the math easier, but, saying that at each instant in the history of an economy, its entire future is predefined seems nonsensical.
  
• Open, efficient markets will create full employment.
  
• The latest New Classical thinkers use Dynamic Stochastic General Equilibrium (DSGE models) as their workhorse. Gots to figure out how to code me up some of those ...
  

According to Shidelsky, New Keynesian economics uses a lot of the same concepts, but then tacks on Keynesian concepts. So let's move on to Keynesian economics.

• All markets have uncertainties that cannot be predicted by equilibrium models.
  
• Agents will hold rather than invest or spend money when high levels of uncertainty make them afraid. This goes into models as LM: Liquidity/Money.
  
• Risk is measurable, uncertainty is not.
  
• Following the crowd is a strategy that diminishes uncertainty.
  
• Government regulation can help manage uncertainty.
  
• While Classical economists believe that slumps should be combatted solely by the central banks increasing the money supply, Keynesians also believe that direct government stimulus (spending) may be necessary. This assures that the money doesn't just get created, but also get spent. Re what is going on now: the Fed has increased the money supply by a factor of 3, but mostly the money is just being hoarded.
  
• Say's Law is repudiated. The current Great Recession is attributed to a lack of demand, which Say's Law says should not exist. Demand problems, which can be acerbated by agents' uncertainty making them save rather than spend, are the root of busts, rather than supply problems.
  

Shidelsky sayes New Keynesians attribute market failures -- booms or busts -- to "asymmetric information". For example, in the 2008 meltdown, the traders, ratings agencies, and other insiders knew that the CDOs (Consolidated Debt Offerings) were crap, the people they were selling them to absolutely didn't.

Ahhh! I had forgotten about this. The stick figure cartoon that completely explains the subprime crisis! Subprime => sublime!

Another thing that is completely ignored by classical theories is that in our globalized era, capital moves around much easier than labor. Labor does move, as view immigrants in lower (or higher) paid jobs worldwide, but it's a lot harder to physically move your person, and possibly your family, than it is to do an international funds transfer. So the labor market must adapt to changing conditions much more slowly than the capital market. Which makes (New) Classical models === shit.

The next section of the book talks about Keynes. I guess I'll have to read a bio at some point (it would join Albert Einstein and Harpo Marx on the list of biographies I've read -- I've never been much on them). He didn't like math. He believed in economist intuition, pretty scary. He got his experience with economics as an investor. He fairly successfully managed his own, his friends, and some institutional funds. He was political and a persuader, like Paul Krugman and Joe Stiglitz are today. He died young, age 62 (says the 62 YO man), in 1946.

So now, let's look at history according to, which school of economics was winning.

1. From the 18th century until the Great Depression, Classical economics ruled.
   
2. Keynes formulated his ideas and published them during the Great Depression. Keynesian principles, in the form of the Bretton Woods agreements, were used to build The World Order after World War 2. But in the 70s, the Keynesians pushed too hard for government control and regulation. Additionally the stagflation (high unemployment and inflation both, which is not supposed to be possible) of the late 70's gave more ammunition to the conservatives.
   
3. The New Classical domination begins in the 80s, with Ronald Reagan and Margaret Thatcher deregulating everything, busting unions, and otherwise trying to regain the classical ideal of completely free, unregulated markets. Milton Friedman ("the gnome of Chicago???") was the intellectual leader of the New Classical economists. An additional factor that is mentioned: the fall of the USSR and the general failure of Communism took the pressure off of Capitalism to appeal to the working classes. So the capitalists basically then put the pedal to the metal.
   
4. The Great Recession now has New Keynesians on the upsurge. Particularly since the predictions of the New Classical economists -- notably hyperinflation from the 3x money expansion that the Fed has done -- have been completely wrong, while the predictions of the New Keynesians -- notably that austerity measures in face of a weak recovery would throw countries back into recession -- have been mostly right.
   

Skidelsky then compares the periods 2 and 3 above. In general, he finds that the economy did much better during period 2. Interesting that there were no recessions (GDP annual growth less then 3%) in period 2, while there were 5 recessions during period 3. Period 2 had average GDP growth of 4.8% versus 3.2% in period 3 -- 50% greater growth rate before "greed is good" became ascendant. Unemployment was also lower, 4.8% versus 6.1% Meanwhile, income and wealth inequality have skyrocketed in period 3, with the 1% now holding 40% of wealth, while the bottom 40% of Americans have less than 1% of the wealth.

Keynes was actually as much of a philosopher as he was an economist. He thought that economy, wealth, and money were only means to the end of achieving "the good life". Instead we have:

Today, wealth increase is the only goal that Western society has to offer.

And:

Jesus Christ said, "It is harder for a camel to go through the eye of the needle, than for a rich man to enter the kingdom of God." -- one of his teachings that has been universally ignored since the advent of Protestantism.

OMG, the number of times I have thought about all those Escalades lined up, waiting their turn to try to drive through the eye of a needle! So sad that irony is completely lost on modern evangelical christians :-(

Keynes thought that capitalism would be phased out once its work was done; that there'd be plenty for everyone; and that we'd all have 15 hour work weeks. People of his time simply could not imagine the greed and the selfishness that would become sanctified from the 80s onward.

Part of this is in the nature of money. I can look at my possessions, and make a judgement, "I have enough of those". With money, it's harder. It's hard to know that you have enough money to last to the end of your life, given that you are (rightfully) afraid to rely on Social Security to take care of you in your retirement.

Ha ha, Keynes preference was for

arranging our affairs in such a way as to appeal to the money-motive as little as possible, rather than as much as possible.

Keynes also rejected economic Darwinism. Interesting too, he predicted that our modern system of huge corporations and mega-banks would be much more liable to shocks than the older individual investor model, which does seem to be the case.

Similarly, the New Classical economists have stated that the new forms of derivatives, of which CDOs are one example, help to create a "perfect market", where every type of trade imaginable can be made. And they further claimed that this "perfect market", with every form of asset interconnected with every other, would provide greater stability against shocks and bubbles bursting. Instead, it did the opposite: one component went bad and brought the other components under stress as well.

Which reminds of a thought I've had re the massive failure of the ratings agencies (S&P, Moody's and Fitch). They had no math, but you would think that, when creating an investment vehicle from multiple components, the rating cannot be greater than that of the lowest rated component. Instead, I think they basically did the opposite: use the rating of the highest rated component. These guys are getting sued and fined pretty heavily, but as with everything about 2008, there will be no criminal charges. Here is an in-depth article on the failure of the ratings agencies by Matt Taibbi of Rolling Stone.

An interesting point: Canada pretty much sailed through the 2008 crisis. No banks had to be propped up. Why? Because banking in Canada is not such big business as it is in the US and UK, such that Canadian banks did not have the political clout to get themselves deregulated. So they could not partake in the type of risky behavior that caused US and UK banks to fail.

So going forward?

1. Break up the big banks. Now that the mega-banks know that their failures will be covered by the federal government (i.e. our tax dollars), they are back to the same risky behavior and wealth-extraction-quick schemes that led to the 2008 collapse.
   
2. Put back in place some version of Glass-Steagal, which separated commercial and investment banks and insurance companies.
   
3. Require banks to have more reserves and less leverage.
   
4. Help with the growing inequality by more heavily taxing "unearned" wealth, particularly via estate taxes.
   
5. Wealth in the US has to quit going so much into the pockets of the 1% and into investment in new businesses, products, and infrastructure. Everyone is uncertain and sitting on their money (keeping it liquid) instead of buying and investing.
   

There is a weird note towards the end of the book. Skidelsky proposes changing how undergraduate economics is taught, to make it much broader, and he proposes splitting microeconomics from macroeconomics for postgraduate study. Seems to me like that will take a long time to make a difference with current problems. But, as I said at the start, Economics as a science or discipline certainly does not impress me as it is now.

Seems like I've tried to cover a lot of the topics of this book, but I have just scratched the surface, and have, I am sure, incorrectly summarized some of the points. But surprisingly, this is not a long book and is a fairly quick read. It was the best overview of economics that I have read so far. So I do recommend it highly.

To summarize:

• Classical economics => free markets good, government bad. And, as this is a conservative formulation, of course feel free to ignore any and all data to the contrary. Government attempts to affect booms and busts always just make things worst. The Great Depression and the Great Recession were both caused mostly by there being too much money and credit in circulation, which created bubbles that popped.
  
• Keynesian economics => uncertainty exists, free markets are imperfect and will go through booms and busts, government money policy and stimulus spending can help with these.
  

So what is it that discourages me? The (New) Classical models, with their end-of-time predictability, seem completely bogus. It's funny, my hero, Paul Krugman, I think in the prefix to "Fix This Depression Now", since it's the only book of his I've read, says somewhat, "I wanted to study psychohistory, like Hari Seldon of the Isaac Asimov Foundation novels -- and economics is as close as I could get."

So what is really lacking to me is sociobiological concepts. As I see it, bubbles are driven by herd behavior. Something starts trending up, and everyone rushes to get onboard. And then, when bubbles pop, herd psychology pushes everyone to sell, sell, sell, even if they're losing money.

But, Consumer Confidence numbers are published. Are Business Confidence numbers also published? I'll have to research that. Those could easily fit into models to try and measure uncertainty.

But instead of realistic sociobiology in economics, we have explicit anti-science -- how can we prove no matter what, that free and unregulated markets are the best, regardless what of all available data says?

OK, back to the books, study continues ...