11 February 2013

Expecting the Unexpected: A Litany In Times of Plague - Diogenes the Dog

Caroline Baum has an interesting interview with economist Edmund Phelps titled, Expecting the Unexpected.

I have linked to it, but given the dismal sounding nature of the topic I suspect many would bypass it.

It is one of the better pieces by Caroline Baum which I have seen. Perhaps it is because she allows Phelps to speak in his own words at such length, and asks her questions well and in deference to the knowledge of the speaker, probingly.

I find it a bit discouraging that there is no mention of the tremendous effort that is made to hide information and to distort it wilfully, to manage perception, and to circumvent the rules through fraudulent behaviour.   And as we have seen,

That seems a little worse than naive, given that we live in the shadow of a pandemic of fraud and manipulation in the markets, from CDO to LIBOR.  I think it is a mistake to assume good faith and an excess of virtue when very large sums of money are involved, especially in a relativistic culture where greed speaks lies to deceit.

This trend to faux arithmetic determinism by making reality crushing assumptions in economics has been cited by many including Nassim Taleb of course, and mathematician Benoit Mandelbrot in The Misbehaviour of Markets. which pretty well takes some of the pretensions of the Chicago School apart, piece by piece.

Here are a few interesting excerpts.

Expecting the Unexpected: An Interview With Edmund Phelps
By Caroline Baum
Feb 11, 2013

In 2006, the Royal Swedish Academy of Sciences awarded the Nobel Memorial Prize in Economic Sciences to Edmund Phelps "for his analysis of intertemporal tradeoffs in macroeconomic policy." Phelps showed that, contrary to the original Phillips curve, there is no long-run trade-off between inflation and unemployment, only a short-term one. Translated into lay speech: You can fool some of the people some of the time and reduce unemployment by paying workers what looks like a higher wage. Eventually, they wise up to the fact that their higher nominal wage is a function of higher inflation, not a higher real wage. Unemployment reverts to its so-called natural rate.

Phelps is the director of Columbia University's Center on Capitalism and Society. I talked with him over the phone on Jan. 25 and Feb. 4 about his views on rational expectations: the notion that people’s expectations of economic outcomes are generally right and policy makers can’t outsmart the public....

Q: So how did adaptive expectations morph into rational expectations?

A: The "scientists" from Chicago and MIT came along to say, we have a well-established theory of how prices and wages work. Before, we used a rule of thumb to explain or predict expectations: Such a rule is picked out of the air. They said, let's be scientific. In their mind, the scientific way is to suppose price and wage setters form their expectations with every bit as much understanding of markets as the expert economist seeking to model, or predict, their behavior. The rational expectations approach is to suppose that the people in the market form their expectations in the very same way that the economist studying their behavior forms her expectations: on the basis of her theoretical model.

Q: And what's the consequence of this putsch?

A: Craziness for one thing. You’re not supposed to ask what to do if one economist has one model of the market and another economist a different model. The people in the market cannot follow both economists at the same time. One, if not both, of the economists must be wrong. Another thing: It’s an important feature of capitalist economies that they permit speculation by people who have idiosyncratic views and an important feature of a modern capitalist economy that innovators conceive their new products and methods with little knowledge of whether the new things will be adopted -- thus innovations. Speculators and innovators have to roll their own expectations. They can’t ring up the local professor to learn how. The professors should be ringing up the speculators and aspiring innovators. In short, expectations are causal variables in the sense that they are the drivers. They are not effects to be explained in terms of some trumped-up causes.

Q: So rather than live with variability, write a formula in stone!

A: What led to rational expectations was a fear of the uncertainty and, worse, the lack of understanding of how modern economies work. The rational expectationists wanted to bottle all that up and replace it with deterministic models of prices, wages, even share prices, so that the math looked like the math in rocket science. The rocket’s course can be modeled while a living modern economy’s course cannot be modeled to such an extreme. It yields up a formula for expectations that looks scientific because it has all our incomplete and not altogether correct understanding of how economies work inside of it, but it cannot have the incorrect and incomplete understanding of economies that the speculators and would-be innovators have...

Q: One of the issues I have with rational expectations is the assumption that we have perfect information, that there is no cost in acquiring that information. Yet the economics profession, including Federal Reserve policy makers, appears to have been hijacked by Robert Lucas.

A: You’re right that people are grossly uninformed, which is a far cry from what the rational expectations models suppose. Why are they misinformed? I think they don’t pay much attention to the vast information out there because they wouldn’t know what to do what to do with it if they had it. The fundamental fallacy on which rational expectations models are based is that everyone knows how to process the information they receive according to the one and only right theory of the world. The problem is that we don't have a "right" model that could be certified as such by the National Academy of Sciences. And as long as we operate in a modern economy, there can never be such a model...

Q: In the world envisioned by rational expectations, there would be no hyperinflation, no panics, no asset bubbles? Is that right?

A: When I was getting into economics in the 1950s, we understood there could be times when a craze would drive stock prices very high. Or the reverse: An economy in the grip of weak business confidence, weak investment, would lead to loss of jobs in the capital-goods sector. But now that way of thinking is regarded by the rational expectations advocates as unscientific.

By the early 2000s, Chicago and MIT were saying we've licked inflation and put an end to unhealthy fluctuations –- only the healthy “vibrations” in rational expectations models remained. Prices are scientifically determined, they said. Expectations are right and therefore can't cause any mischief.

At a celebration in Boston for Paul Samuelson in 2004 or so, I had to listen to Ben Bernanke and Oliver Blanchard, now chief economist at the IMF, crowing that they had conquered the business cycle of old by introducing predictability in monetary policy making, which made it possible for the public to stop generating baseless swings in their expectations and adopt rational expectations. My work on how wage expectations could depress employment and how asset price expectations could cause an asset boom and bust had been disqualified and had to be cleansed for use in the rational expectations models.

Read the entire interview here.

The Tale of Alexander and Diogenes

There is a famous and almost certainly apocryphal story about the cynic philosopher, Diogenes, which was related to us by Plutarch.

As you know, Diogenes believed in the mastery of the self.  He was considered to be eccentric and did outlandish things such as walking about Athens in the daytime with a lit lamp, 'looking for an honest man.'
"According to one story, Diogenes went to the Oracle at Delphi to ask for its advice and was told that he should 'deface the currency.' Following the debacle in Sinope, Diogenes decided that the oracle meant that he should deface the political currency rather than actual coins.

He traveled to Athens and made it his life's goal to challenge established customs and values. He argued that instead of being troubled about the true nature of evil, people merely rely on customary interpretations."
He was said to have lived simply, 'like a dog,' and that this is how the Cynic school of philosophy received its name.
The name Cynic derives from ancient Greek κυνικός (kynikos), meaning "dog-like", and κύων (kyôn), meaning "dog."
In his later life Diogenes was visited in Corinth by Alexander the Great, the king of Macedonia, who would go on to conquer Egypt and India.

Diogenes had been sitting in the sunshine, when Alexander walked up to him and asked what he might do for him, given his deprived state, because he owned only his cloak, having discarded his bowl when he saw a child drinking from cupped hands.

Diogenes looked up at Alexander and said, "You can stand aside, so as not to rob me of the light by your shadow."

Alexander's guards and followers were scandalized at such blatant disrespect for a king.

 And Diogenes asked them, 'Is your lord a good man or a bad man?'   'Good!' they said. 'Then my request is reasonable,' said Diogenes.

And the guards were ready to deal with him harshly, because the implication was that Alexander stood between the people and their natural lives by his own willful pursuit of wealth and power, which was a favorite theme of Diogenes.

But Alexander intervened on the philosopher's behalf, saying, 'If I were not Alexander, I would be Diogenes,'  to which Diogenes replied,  'If I were not Diogenes, I should also wish to be Diogenes.'

Diogenes died at age 89, owning little more than his cloak and his reputation.

After leaving Greece, Alexander went on to conquer most of the known world, and took the Persian title, King of Kings.  Alexander died of an unknown illness, perhaps caused by drinking too much, or poison, or his recurrent malaria, in the palace of Nebuchadrezzar II of Babylon, a few months short of age 33.

There is another version of the meeting between Alexander and Diogenes.  In it, Diogenes was staring at a pile of human bones when Alexander approached, and asked him what he was doing.  "I am searching for the bones of your father," said Diogenes, "but cannot distinguish them from those of a slave.”

The Corinthians built a pillar in Diogenes memory, on the top of which was a dog made of Parian marble.

And so passed the glory of Greece, and the grandeur of Rome.