Good article by Ross Gittins on Economics and Equilibrium

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Ross Gittins has written a very good overview of the failings of neoclassical economics in today’s Sydney Morning Herald:

Self-righting markets and other shibboleths

The article mentions the Dahlem Report, but doesn’t provide a link to it. For those who would like to read it, here it is.

I also wrote a post on the Dahlem Report shortly after it was written, and helped publicise it by placing it on my blog. Given that its tone was in some ways even more dismissive of conventional economics than I am, the title for this post was obvious:

And you think I’m ornery? The Dahlem Report

There are, as Ross implies,  many dissident groups within economics, but these are normally overshadowed–and crowded out of public commentary–by the dominant “neoclassical” school. As a result, most of the public takes what this school says to be all there is to “economics”.

Critics like Paul Ormerod, me, and many others have railed against this over the years–in public talks, in lectures to students in any subjects where we have some control over content, in books like my Debunking Economics or Paul’s Butterfly Economics–but we’ve largely been ignored by the public, since the economy seemed to be working just fine. Just as neoclassical economics said it always would.

And then along came the Global Financial Crisis.

A lot of the problems in neoclassical economics emanate from its methodology–the philosophy underpinning how neoclassical economists build models of the economy–and I cover this in a sample chapter from my Debunking Economics which is available online:

There is madness in their method

The key point that Gittins focuses upon is the obsession with equilibrium. To academics from other disciplines, this obsession appears quaint. Most sciences have concepts too, but they don’t attempt to model the systems at the heart of their discipline as if they are always in equilibrium. They have instead developed methods to analyse the behaviour of these systems when they are not in equilibrium–which is almost all the time (and when they do model equilbrium, their concepts of equilibrium are much broader than that which applies in neoclassical economics, which implies that all agents in the system are in a state of rest).

Instead, neoclassical economists reflect their isolation from the broad sweep of intellectual history by being ignorant of these very methods. I find this stunning–because the most basic such method is part of the education of any engineer, physicist, or mathematician, even if they only do an undergraduate degree in their subject and never become academics. This method is “Differential Equations“, and any engineer, physicist, or mathematician has to do at least an introductory course in these in order to get a Bachelors Degree.

Yet economists can graduate with PhDs without ever coming across them.

Many neoclassical economists think they know about these–after all, the core concepts in neoclassical economics concern things like “Marginal Cost” and “Marginal Revenue”, which are the differentials of “Total Cost” and “Total Revenue” with respect to output: “We don’t know about differential equations? Bah, what nonsense!”

In fact, differential equations are very different beasts from simple differentiation, since they consider the rate of change of variables not with respect to each other, but with respect to time (I’m tempted to provide a Wikipedia link to the concept of “time” for the benefit of any neoclassical readers who don’t know what it is… but I’ll restrain myself). They make it possible to model how the economy–or any other system–will behave when its not in equilibrium.

Instead, even Nobel Prize winners seem to believe that if they abandon the fantasy that the economy is in equilibrium, they will be unable to model its behaviour. Witness this statement from Paul Krugman on his blog when he gave some background to his recent critical essay on economics:

Actually, let me put it this way: the economy is a complex system of interacting individuals — and these individuals themselves are complex systems. Neoclassical economics radically oversimplifies both the individuals and the system — and gets a lot of mileage by doing that; I, for one, am not going to banish maximization-and-equilibrium from my toolbox [my emphasis]. But the temptation is always to keep on applying these extreme simplifications, even where the evidence clearly shows that they’re wrong. What economists have to do is learn to resist that temptation. But doing so will, inevitably, lead to a much messier, less pretty view.

Then this guarantees you’re never going to understand complex systems Paul: the very starting point of complex systems analysis is the modelling of systems–such as the Lorenz Attractor that is the basis of meteorology–which are never in equilibrium.

Ironically, in that same essay Krugman notes that meteorology might be a valid model for economics to follow:

Third, on an interesting point raised by Discover (via Mark Thoma): won’t we eventually have a true theory that’s as beautiful as the full neoclassical version? Well, one thing’s for sure: we don’t have that beautiful final theory now, so the current choice is between ideas that are beautiful but wrong and a much messier hodgepodge. But my guess is that even in the long run it won’t be all that neat. Discover suggests general relativity versus Newtonian physics; but a better model may be meteorology, which as I understand it starts from some simple basic principles but is fiendishly complex in practice [my emphasis].

Well Paul, to understand meteorology, you’re going to have to give up on equilibrium–or rather on the fantasy that a complex system can be modelled as if it is in equilibrium. There are, for example, 3 equilibria in the Lorenz Attractor–all three of which are unstable. Equilibrium is a state in which the Attractor will never be.

I also find it remarkable that intelligent people like Krugman can be so ignorant of developments outside their own field of endeavour. Notice the comment he made that not applying the standard neoclassical economics simplifications like equilibrium “will, inevitably, lead to a much messier, less pretty view”.

Prettiness itself should not be an objective of science. But nonetheless, some of the prettiest objects in science are the result of non-equilibrium dynamics. The Lorenz Attractor is clearly one–take a look at it and you’ll see why people often talk of “the Butterfly Effect” when describing the instability of the weather. But there are many others.

I think my own non-equilibrium models of the economy have a similar beauty–here for example are two from my model of Minsky’s Financial Instability Hypothesis. The first is of an economy without a government sector which undergoes a debt-driven Depression:

The fate is not pretty–the economy collapses as debt rises–but the image is “pretty”.

Both the image and the fate of the next model are pretty–this is an economy starting from the same initial conditions, but which has a government sector that practices counter-cyclical fiscal policy and therefore prevents a debt-induced crisis:

The above is the time path of employment and wages in this model, which is actually a 2D slice through the 4-dimensions of the model: (1) the wages share of output; (2) the employment rate; (3) the debt to output ratio; and (4) government spending as a percentage of output). This next view shows 3 of those dimensions (excluding government spending), and the 2 dimensional view of the previous simulation is shown as a shadow below the 3D shape):

So the output of non-equilibrium models can be “pretty”–it’s just the picture they craft of capitalism that isn’t pretty. It isn’t a system that automatically reaches equilibrium and ensures the best outcome for the largest number of people. It may not be “pretty” in that way, but it is the world in which we live.

As Gittins argues in his piece, we have no choice but to understand that system, and the neoclassical obsession with equilibrium is possibly the major reason why we have not understood it to date.

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20 Responses to Good article by Ross Gittins on Economics and Equilibrium

  1. Hi Steve, I’m amused at how similar the 3D rendering of the first of your two non-equilibrium models looks like water going down the drain or a tornado ripping up the American Mid-West.

    Either analogy seems apt :-)

  2. Steve Keen says:

    It’s a tornado as drawn Bruce–the direction of movement is upwards as the debt to GDP ratio rises–but a better concept is the going down the drain since debt is effectively a negative rather than a positive.

  3. Cinquero says:

    Actually, you may not need more complex theories as a policy maker: just make sure that an equilibrium exists! For debt, the equilibrium may be roduced by rather high interest rates and, maybe, better regulation. Look at Brazil. As an economist, it may be quite nice to play around with theories. As a practician, one should prefer not playing, but to make sure things work out the way we like them to be.

    I’m a follower of socionomics. The Dahlem Reports indicates that the highly intelligent economists did not feel responsible to issue warnings. Indeed, if you follow those who warned for years before the crisis, it was not a nice time for them. And if you don’t have a good position as you have, Steve, most probably won’t even dare to try issuing such solitary statements. The point is in my opinion: everyone could have known, but no one cared. It was a good time as long as it lasted. And you never criticize those who feed you well.

  4. Cinquero says:

    To be honest, I believe that when policy makers refer to economic theories, they have long run out of commonly understandable arguments. They all *wanted* to believe in the theory. The theory itself did not matter at all. It was a signature of the neoliberlism distributed throughout the world by the IMF, the Worldbank etc.

    There central institutions pose a systemic risk to the global social welfare. As Galbraith pointed out: the most severe crises have been trigged by officials and politicians absolving the whole B.S.

    We need to get back to the state of mind where we care again for what happens around us. And it is already starting. The press is more and more stuffed by the “caring type” of stuff (prosecutions, forcing of the SEC against BofA trial, IRS enforcement etc. etc. etc.). Protectionism will rise because it is a sane thing to do (if you do not exaggerate) in order to curb outsourcing (hell, China outsourcing sector increased 32,5% in the first half — the crisis accelerates the structural problems even more because US companies have to reduce costs even more!!!) and bring back jobs to the US — which will of course take down the economy temporarily even more due to (necessary!) restructuring costs.

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  6. Steve Keen says:

    Actually, there were many non-orthodox economists issuing warnings long before the Dahlem Report came out. I was one of them–from as long ago as 1995–but Minsky clearly preceded me, and many economists who were influenced by Minsky made regular warnings about the inevitability of a crisis should the current debt-driven process continue.

    Some of the relevant names include Wynne Godley, Jan Kregel, Randy Wray, Marc Lavoie, the Levy Institute in upstate New York which has kept Minsky’s analysis alive, and which will host a summer school and conference on Minsky next year.

    One of the signatories to the Dahlem Report, Thomas Lux, is a friend of mine, and he’s done his bit to point out the flaws in conventional economics over the years–as well as develop some very advanced new ways of modelling economic and financial processes. Another signatory, Alan Kirman, is a very respected economist in general, with publications in mainstream journals including a very important reaction to critiques of neoclassical economics entitled “The Intrinsic Limits Of Modern Economic Theory: The Emperor Has No Clothes” (The Economic Journal, 99 [Conference 1989], 126—139). David Colander, the lead signatory, writes a best selling textbook but unlike most textbook authors, is aware of the flaws in neoclassical economics.

    But none of these were prominent in warning about the crisis. It’s just one of the idiosyncracies of life that their critique of economics has received the prominence it has, while the much more specific critiques of Wynne Godley et al haven’t seen the light of day today.

    We’re also lucky that economics, and academia, are not homogeneous fields. Generally life is pretty tough for a non-orthodox economist, but there are some universities around the world where they are dominant or at least maintain a balance of power. I’m lucky to work at one of those (UWS), Randy Wray works at the University of Missouri Kansas City, which is another, and so on.

  7. Tel says:

    If you gave government a Lorenz attractor and asked them to stabilise it, not only would they fail completely but the result would be a bigger mess than it started out.

    Ross Gittins presents ignorance bordering on dishonesty:

    But the belief in self-righting markets also fits nicely with the political philosophy of libertarianism – the supremacy of freedom of the individual, the minimal need for governments and taxes.

    And it suits business interests, who want maximum freedom to make a buck in any way they see fit.

    When was the last Libertarian government we had in Australia? Howard? Was John Howard a Libertarian? Howard who introduced anti-terrorist laws allowing anyone to be locked away for weeks without even one phonecall. Howard who cracked down on rights of assembly and free speech. Howard who got involved in government war mongering despite no Democratic mandate, and an admission that he knew the people of Australia were not interested.

    That was supposedly liberty?

    Perhaps Hawke and Keating were Libertarians? Those with the famous “Accord” regulating wages and creating a deal between big government and big unions. Keating who created a centralised system for settling industrial disputes, made it illegal for employees to negotiate terms.

    Somehow these straw-man Libertarians get the blame for the Global Financial Crisis… where were these guys?

    But surely, you may object, the whole discipline of macroeconomics is the study of how to stabilise the economy as it moves through the business cycle. Well, it used to be. Increasingly, however, it’s been about trying to prove that governments are incapable of influencing the course of the macro economy and that what seems to be a cycle of deficient or excessive demand isn’t really.

    Oh please. Keynesian monetary policy has been standard fare in the US and the UK and Australia for decades. Right up to and including the GFC, right to the present day. If the Keynesians slipped up and failed with their stabilisation efforts then they can have the honesty to sit and blame themselves for doing it wrong.

    What would you call Obama’s massive TARP and stimulus package? Is that Libertarianism? Sounds more like Keynesian on steroids, and employment in the USA continues to contract.

    Scapegoating the Libertarians… good article my foot.

    This bubble was pumped and blown by government intervention, primarily artificially low interest rates coming out of the USA, and loose monetary policy from the Fed, and deliberately pushing banks to lend money to high-risk poor home owners (encouraging them to buy a far more expensive house than they needed) in order to achieve political objectives.

    May Fairfax continue on their fine road to bankruptcy for pedalling trash.

  8. Steve Keen says:

    You have failed to distinguish between the economic theory that Gittins was talking about and economic policy Tel.

    Of course there were massive interventions in the actual economy, and you could typecast them as Keynesian quite easily (so long as you used a textbook definition of Keynes). But economic theory argued that the best of all possible outcomes would result from zero government interference in the market. This is the perspective that Gittins was commenting on.

  9. Tel says:

    It’s an article discussing the GFC so it only makes sense to consider such a thing in the light of the policies and historic events that were part of the larger chain of cause and effect. It would be naive to expect any reader to interpret this as a dry discussion of theory with a dose of blame-pointing regarding policy.

    To conveniently ignore the massive interventions and government sponsored debt expansion, only to attempt to lump the blame on people seeking individual liberty is downright dishonest.

    Gittens actually gives the impression that the whole GFC just happened, all by itself, as one of those things that proves free markets can’t be trusted. Yes market bubbles are a matter of historic record, yes they do happen, but the scale of the current crisis is something again. The only explanation is that assets were pumped by policy.

    Paul Keating was already talking about the hidden inflation in Australia back in 2007, here’s the link:

    http://www.abc.net.au/lateline/content/2007/s1945485.htm

    Now the higher wages which are in the inefficient sector of Australia like infrastructure, transport et cetera, these are being subsidised. That inflation rate which is running at about 4 per cent is being subsidised by zero per cent coming across the wards. If you’ve got half the economy doing four and half doing zero, the inflation rate is two. That’s where Mr Costello gets his 2 per cent from, nothing clever from him.

    Keating was only talking about Australia, and if it had just been a matter of Australian government policy, we wouldn’t have come down nearly so hard. Mostly we have been dragged down by the USA, who had a deliberate policy of continuous debt expansion.

  10. MichaelM says:

    Nice to see Ross Gittins acknowledging weakness in economic orthodoxy. However, I used to read his columns only a few years ago and despair at their blinkered orthodoxy. I suppose its a good thing if he broadens his view, however belatedly.

  11. Zippy says:

    As long an Universities continue to teach one school of Economics all Economists will be painted with the same brush.

    While I appreciated that there were different schools of economics I had decided in my head that they were either dis-proven or unproven.
    It never occurred to me that the alternative might actually be more correct!

  12. Anarcho says:

    Good article, although it looses points for this:

    “the political philosophy of libertarianism – the supremacy of freedom of the individual, the minimal need for governments and taxes.”

    The term libertarian was first coined in 1858 by an anarchist as an alternative for his anti-state socialism:

    http://anarchism.pageabode.com/afaq/150-years-of-libertarian

    Genuine libertarians argue that individual freedom does not stop at the boundaries of private property and that wage-labour and landlordism are just as oppressive as states (which exist, of course, to defend private property and the power of its owners).

    Since the 1970s, the free-market right have tried to steal the term “libertarian” to describe their vision of private serfdom, but there are still anarchists around to protest this mis-appropriation by the right of a great label of the left!

  13. Philip says:

    Yes, I have found the use of the word libertarian to refer to the defense of private property to be strange considering that the social relationships that flow from the institution of private property is that of dominator hierarchy.

    It is obvious when examining a typical institution of private property: the capitalist firm. I don’t think humans have created a more psychopathic and organizationally totalitarian institution than this one, along with the fascist and Bolshevist state systems.

    Austrians and Marxists have got one half of the equation right, but neither are consistent with the original meaning of the word libertarian (that is, both the state and private property are authoritarian institutions).

    Hayek wrote the book The Road to Serfdom, but what he favored and advocated was the road to private serfdom.

  14. cscoxk says:

    The graphs are “beautiful” but there is a simpler model of economic systems which is illustrated with the explanation of behaviour of social insects like bees and ants.

    We can describe the economic activity in collecting food of an ant colony with a description of the “rules of behaviour” of an ant.

    If I find food then collect it and start to move in the general direction of the nest and leave a trail.

    If I hit a trail then follow the trail.

    If I meet an ant see if it is carrying food. If no food with the other ant continue down the path. If food wait for an ant that has no food.

    If I have no food then follow a trail. If I find a trail junction then follow the strongest trail.

    If I have no food and am not on a trail then wander around at random looking for food.

    The scent I drop fades over time.

    These simply rules results in complex patterns of behaviour that can be easily modelled using computational methods based on “ant agents”. The models we construct by building a system looks like the behaviour of an ant colony particularly when we introduce external events such as the breaking of trails and see what happens.

    We can change the “rules” and we can see what happens. For example, what happens if we change the rules associated with meeting another ant on a trail?

    We can describe “markets” in the same way and we can model them by having agents “interacting” and observe what happens to the models. The rules of behaviour are relatively simple but the total activity is complex.

    Economic modelling using general equilibrium is like modelling an ant colony by taking snap shots of the ant trails over time and observing changes in the patterns of trails and trying to deduce what will happen in the future by looking for correlations with other variables such as the initial distribution of food, or the amount that each ant can carry, or the amount of scent each ant on average can drop. Such models explain nothing because the patterns are the result of the activity and cannot be predicted from other patterns.

    If you want to change the system you look for changes in the way interactions are carried out. If we want to fix the money market we are best to look at the rules we use in the money market system and vary them.

    At the moment we increase the money supply through loans against existing productive assets. We rarely increase the money supply with loans against new productive assets. We might use loans against old assets to build new assets but it is unusual to give loans backed by future assets.

    What if we biased the cost of money so that targetted future productive assets had lower finance costs through loans of low or zero interest?

    If the targetted assets are assets where there is a propensity for asset inflation (houses, stocks) then this gives a mechanism to prevent such bubbles by creating enough loans to satisfy demand with new assets.

    If the targetted assets are ones that have a general social good such as investments in renewable energy then we would find that those investments would occur instead of investments in energy plants that burn fossil fuel.

  15. Steve Keen says:

    There are problems in using multi-agent models for complex systems cscoxk,

    The most important of which are the very “emergent properties” that multi-agent models try to uncover. Those these are obvious at the systemic level–in economics this includes the development of financial crises–the individual level behaviour that gives rise to this is not at all obvious. So I prefer to work with “tops down” differential equation models.

    A second reason for this is that–apropos my comments on the generational debate which sprung up here recently–is that the structure of society does more to determine the performance of that society than the operations of individual agents within it. Again this is my reason for preferring tops down modelling to multiagent. One day, when we’ve done the former well enough, I’ll have time and interest for the latter.

  16. cscoxk says:

    Steve,

    I understand exactly where you are coming from. It would be great if we could know the final outcome and work back from the solution. Unfortunately the odds are about as good as winning the lottery.

    The reason is that there an “infinite” number of possible solutions and trying to pick a good one – which is what you do when you start at the top – is unlikely. You may fluke it but the odds are way against it happening. Good search algorithms in complex spaces are ones where you start with a solution – modify it a bit in dozens of different ways – then pick the ones that give the best results and move on from there.

    We all like to think we can see where things are going but inevitably things do not turn out as we expect. An evolutionary approach is one where we can say – “that looks like a good idea let us give it a go”. If we try it and see it is different to what is expected then we adjust and try something else. Unfortunately bureaucracies and politicians and economists are uncomfortable with this approach. They seem to want “certainties” instead of probabilities and they do not like to change their minds.

    For example I believe very confidently that decreasing the cost of finance for new assets relative to the cost of financing existing assets will stabilise the monetary system – but I cannot be sure until it is tried. If it does not work as expected then we need to be in a position to rapidly adjust and say – ‘that did not work because of xyz but it did make a bit of an improvement because of pqr so let us follow the pqr path’.

    Evolutionary systems do not work by knowing the answer and working towards them. Evolutionary systems work by trying things out and killing off the ones that do not work. We have a system where creating money ONLY through debt backed by existing assets, including other debt, does not work but we seem unable to “kill it off” and try something else.

    Today I presented the idea of giving zero interest non recourse loans to create productive assets and at the same time create new money “backed” by possible future assets. I was told “that does not obey the principles of double entry bookkeeping so it cannot even be considered”.

    Hello.

    Still I am undeterred and I will continue to press on and try to get someone, somewhere to put new asset creation at least on an equal footing relative to financing costs to the finance cost of purchasing old assets. The trick is to make the changes small enough that they “silp in” without people noticing and once they are in and work they become difficult to dislodge.

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  18. davo says:

    Steve, do you know why many economists don’t have the training in applied mathematics necessary to at least handle ordinary DEs in mathcad? It’s not like you’d need to go through the full process of learning analytical solutions – you could go straight to the application of DEs to various scenarios.

    If any maths, science or engineering student can learn them in 1st and 2nd years, why not economics students? It is time for compulsory mathematics subjects in economics courses?

  19. Steve Keen says:

    It’s a weird one davo,

    They seem to think that they’re better at teaching students “the maths they need to become economists”, but my experience as a first year undergrad doing both was that the Quantitative Methods lectures literally skipped 7 lines of derivation in every line written on the blackboard (I entertained myself during lectures by working this out). I realised that all my fellow students who weren’t doing math were taking this stuff on faith.

    I think it is time for that–though there’s also an argument for a history of economic thought oriented course–and I’ve recommended as such in a chapter in a new book on teaching heterodox economics.

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