On Ukraine: the return of Multipolarity and Hard Power

I've had numerous requests to comment on the conflict in Ukraine, but have been too busy to write anything. 

For background on the situation, I highly recommend the discussion in the video below, released March 3 2022.

To save time, just listen to the presentations by Mearsheimer and McGovern, and their final comments at the end of the video. Both present historical details from the last decade or so that will shock people who only pay attention to mainstream Western media. (Also in the discussion: Jack Matlock, former US Ambassador to the Soviet Union, and Ted Postol, MIT professor and missile expert.)

Ray McGovern is a retired CIA analyst who served as Chief of the Soviet Foreign Policy Branch and preparer/briefer of the President’s Daily Brief. I featured another interview with him in an earlier post on the US catastrophe in Afghanistan: Tragedy of Empire / Mostly Sociopaths at the Top.

Corey Washington and I interviewed John Mearsheimer for the original Manifold, but the episode was not released. It's possible that I might release it some time in the future. 

Mearsheimer has appeared in many posts on this blog. See this March 1 2022 interview in The New Yorker: Why John Mearsheimer Blames the U.S. for the Crisis in Ukraine.

While military and diplomatic aspects of the conflict in Ukraine are worthy of attention, far more important are the long term consequences of Western hysteria and economic war on Russia. Tacit support for Russia from China, India, Brazil, Turkey, OPEC states, indeed perhaps the majority of the world population, may presage a new era of multipolarity and hard power confrontation between great powers.

Why do educated citizens of the countries listed above understand the situation better than the typical American or European? Because they are familiar with Western media propaganda and the history of US imperialism. They are much more likely to understand the facts described by Mearsheimer and McGovern about the recent history of NATO, Ukraine, and Russia leading up to this conflict.

PS I'm surprised there isn't more discussion of systemic risks from defaults of highly networked financial entities that are affected by sanctions on Russia.

This looks dangerous -- like the Lehman Brothers bankruptcy in 2008. Or am I missing some structural reforms that prevent that from happening again? (Maybe the earlier round of sanctions have already decoupled Russia enough...) Or will the central banks that effectively run our economies now simply issue a blanket put, allowing all of our clever money men to go back to sleep? People used to complain about "zombie companies" in some countries with excessive state intervention in their economies. It looks to me like we've had zombie financial markets for some time now...

See Notional vs net: complexity is our enemy (2008).

 

 

Added from Comments: 

Of course I think individuals in TW and UKR have every right to vote / fight for the government they want. 

But they are not likely to get their way as the issue is much more important to their giant neighbor (RUS, PRC) than to the USA or soft Europeans in Brussels. 

They are probably better off negotiating a peaceful coexistence with the nearby great power. Finland "Finlandized" itself and that was probably the best it could do... 

What you are seeing right now in UKR is what great power realists like Mearsheimer *predicted* would happen IF the West gave too much hope to UKR without being willing to actually back it up. 

Now, you may say that Joe Smith in Iowa *should* want to back up UKR or TW, send his son to fight on the front lines there. But it is not the case and we know that. We also knew it 10-15y ago when NATO expansion mischief got started and Mearsheimer made his early cautionary statements on this, as did Kennan, Nitze, Perry, Sam Nunn -- all the old cold warriors who ACTUALLY DEFEATED USSR and understood things better than today's leaders. 

US won't even sanction RUS energy imports to this country... How much pain are we willing to endure for UKR? 

We're going to fight this war to the last Ukrainian... If there isn't a negotiated settlement soon UKR will end up like Iraq and Afghanistan -- abandoned by the US and destroyed. 

I can predict something very similar for TW, even though I have extended family living there right now. Does that count towards emotional commitment / empathy? I'm descended from KMT military officers on both sides of my family tree! 

TW should negotiate for the best deal it can get from PRC and not count on the US to protect it. 

###### 

US war hawks want to see PRC blow itself up fighting for TW. The conflict will destroy Asian economies and leave USA largely unscathed (just as WWII did). They don't care about the well-being of ~2-3 billion Asians.  

Some of them just can't help themselves and want to see RUS blow itself up fighting in a UKR trap. But this group is very stupid as they are driving RUS into the arms of PRC and that is going to be very bad for USA. 

Some US war hawks are smarter than others...

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US to Ukraine, pointing at Russia: "Let's you and him fight."

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William Burns is Biden's CIA Director, and was Ambassador to the Russian Federation. What did he write about Ukraine and NATO expansion? From Peter Beinart's substack:

Two years ago, Burns wrote a memoir entitled, The Back Channel. It directly contradicts the argument being proffered by the administration he now serves. In his book, Burns says over and over that Russians of all ideological stripes—not just Putin—loathed and feared NATO expansion. He quotes a memo he wrote while serving as counselor for political affairs at the US embassy in Moscow in 1995. ‘Hostility to early NATO expansion,” it declares, “is almost universally felt across the domestic political spectrum here.” On the question of extending NATO membership to Ukraine, Burns’ warnings about the breadth of Russian opposition are even more emphatic. “Ukrainian entry into NATO is the brightest of all redlines for the Russian elite (not just Putin),” he wrote in a 2008 memo to then-Secretary of State Condoleezza Rice. “In more than two and a half years of conversations with key Russian players, from knuckle-draggers in the dark recesses of the Kremlin to Putin’s sharpest liberal critics, I have yet to find anyone who views Ukraine in NATO as anything other than a direct challenge to Russian interests.” 

While the Biden administration claims that Putin bears all the blame for the current Ukraine crisis, Burns makes clear that the US helped lay its foundations. By taking advantage of Russian weakness, he argues, Washington fueled the nationalist resentment that Putin exploits today. Burns calls the Clinton administration’s decision to expand NATO to include Poland, Hungary, and the Czech Republic “premature at best, and needlessly provocative at worst.” And he describes the appetite for revenge it fostered among many in Moscow during Boris Yeltsin’s final years as Russia’s president. “As Russians stewed in their grievance and sense of disadvantage,” Burns writes, “a gathering storm of ‘stab in the back’ theories slowly swirled, leaving a mark on Russia’s relations with the West that would linger for decades.” 

As the Bush administration moved toward opening NATO’s doors to Ukraine, Burns’ warnings about a Russian backlash grew even starker. He told Rice it was “hard to overstate the strategic consequences” of offering NATO membership to Ukraine and predicted that “it will create fertile soil for Russian meddling in Crimea and eastern Ukraine.” Although Burns couldn’t have predicted the specific kind of meddling Putin would employ—either in 2014 when he seized Crimea and fomented a rebellion in Ukraine’s east or today—he warned that the US was helping set in motion the kind of crisis that America faces today. Promise Ukraine membership in NATO, he wrote, and “There could be no doubt that Putin would fight back hard.” 

Were a reporter to read Burns’ quotes to White House press secretary Jen Psaki today, she’d likely accuse them of “parroting Russian talking points.” But Burns is hardly alone. From inside the US government, many officials warned that US policy toward Russia might bring disaster. William Perry, Bill Clinton’s Defense Secretary from 1994 to 1997, almost resigned because of his opposition to NATO expansion. He has since declared that because of its policies in the 1990s, “the United States deserves much of the blame” for the deterioration in relations with Moscow. Steven Pifer, who from 1998 to 2000 served as US ambassador to Ukraine, has called Bush’s 2008 decision to declare that Ukraine would eventually join NATO “a real mistake.” Fiona Hill, who gained fame during the Trump impeachment saga, says that as national intelligence officers for Russia and Eurasia she and her colleagues “warned” Bush that “Putin would view steps to bring Ukraine and Georgia closer to NATO as a provocative move that would likely provoke pre-emptive Russian military action.”

Oh, there's some historical background to all this? Some context? Wait I'm told every day this crisis just happened because Putin went crazy and wants to rebuild the USSR / Russian Empire. 

Who is full of crap? Western governments and media today, or our CIA Director and former Ambassadors and Secretaries of Defense? The whole world ex-USA/EU can see this. It's only Westerners who are brainwashed.

Added March 7 2022: This is a long Chinese analysis of the military aspects of the war so far. They also cite Oryx estimates. Note comparisons near the end of Russian and PLA capabilities.

https://m.guancha.cn/WangShiChun/2022_03_06_629031.shtml

More from comments:

I certainly sympathize with "Putin bad", "Russia bad place for me to live", "democracy good" sentiments. 

But suppose the realistic possible outcomes are: 

1. Ukr is dominated by Russia but not destroyed in a war 

2. Ukr is dominated by Russia after a brutal war, with its economy destroyed 

3. (Low probability) Ukr escapes Russian domination thanks to strong US support (avoiding WWIII).  

4. (Low probability) US strongly supports Ukr, leading to MAD, WWIII 

To be very definite, suppose that 

I. Given actual past US policies of ~2010-2022 probabilities are P(#1) = P(#2) = 45% and P(#3) = 9% and P(#4) = 1% 

II. Following advice of Mearsheimer, frmr SecDefs Perry and McNamara, CIA director Burns, etc. etc. we have P(#1) = 95% P(#2) = 4%, others much less than 1%. [ i.e., this is a counterfactual scenario that, in my opinion, turns out better! ]

 

I think this is a REALISTIC characterization. You may disagree. Under my assumptions II is better than I. 

But this is not primarily a normative or moral discussion... we don't disgree there.

Note, in a standard utilitarian framework P(#4) dominates everything else!

Skidelsky, Against Economics (NY Review of Books)

From the NY Review of Books, an article entitled Against Economics, which reviews the recent book by Robert Skidelsky.

Money and Government: The Past and Future of Economics

Robert Skidelsky
Yale University Press

... Before long, the Bank of England (the British equivalent of the Federal Reserve, whose economists are most free to speak their minds since they are not formally part of the government) rolled out an elaborate official report called “Money Creation in the Modern Economy,” replete with videos and animations, making the same point: existing economics textbooks, and particularly the reigning monetarist orthodoxy, are wrong. The heterodox economists are right. Private banks create money. Central banks like the Bank of England create money as well, but monetarists are entirely wrong to insist that their proper function is to control the money supply. In fact, central banks do not in any sense control the money supply; their main function is to set the interest rate—to determine how much private banks can charge for the money they create. Almost all public debate on these subjects is therefore based on false premises. For example, if what the Bank of England was saying were true, government borrowing didn’t divert funds from the private sector; it created entirely new money that had not existed before.

[[ Certainly central banks influence the money supply, but the degree to which they control animal spirits, lending practices and standards, the price of credit risk in general, etc. via a single part of the yield curve is highly debatable, dependent on many factors such as investor psychology and recent events, etc. etc.  There is no doubt this is a complex question worthy of deep analysis ... 

At any instant in time there is a certain level of tolerance for borrowing from the future (private and public debt), and merely by changing this level of tolerance one can in effect create money out of thin air ... This level of tolerance is a completely emergent phenomenon and no one fully controls it. ]]

... one of the most significant books to come out of the UK in recent years would have to be Robert Skidelsky’s Money and Government: The Past and Future of Economics. Ostensibly an attempt to answer the question of why mainstream economics rendered itself so useless in the years immediately before and after the crisis of 2008, it is really an attempt to retell the history of the economic discipline through a consideration of the two things—money and government—that most economists least like to talk about.

On the question of whether academic economists understand how the world works, I'll just reiterate that at the time of the last financial crisis (circa 2007-2008) I became aware through direct experience that many very prominent economists did not know what a Credit Default Swap was, did not know how the credit markets actually worked, did not know how credit risk was priced. Instead, their mental model consisted of coarse graining over all of this activity (quants, traders, mobs, speculators, thieves, fraudsters) as simply a (more or less) rational and efficient market not worthy of deep inspection.

They will all deny it now, of course. But I was there.


Note added: In the 1990s, in part due to the collapse of the Soviet empire and resulting mass emigration of top scientists to the West, there were very few opportunities in theoretical physics and related fields for young researchers. Consequently large numbers of extremely talented people left the field (largely against their will) and perhaps most of them ended up in finance. As might be expected a large number of big brains began thinking about previously obscure topics such as options pricing (derivatives, Black Scholes), credit risk, the yield curve, etc. Immediately it was noted, by myself and others, that methods from imaginary time quantum mechanics, path integrals, etc., could be applied to the pricing of derivatives -- especially exotic derivatives which had, up to that time, required significant computational resources to simulate.

The yield curve and credit derivatives are especially challenging problems. One reason is that they deal with a potentially infinite (if a continuous curve is assumed) number of degrees of freedom. As one of my former Caltech-Harvard collaborators (by the 1990s a quant-trader, now a hedge fund magnate) described it, modeling the yield curve compared to pricing equity derivatives is like quantum field theory compared to simple quantum mechanics.

In modeling the yield curve one immediately asks: what are the underlying dynamics? What are reasonable consistency conditions? What is the impact of a "shock" like a change in the Fed funds rate? A moment of reflection reveals that market psychology plays a huge role in setting the model parameters... A bit of historical investigation shows radical changes in the yield curve (and, consequently, the effective "money supply") over time. One can in effect create money out of thin air!

Manifold Podcast #21: Tyler Cowen on Big Business, Socialism, Free Speech, and Stagnant Productivity Growth

Polymath and economist Tyler Cowen (Holbert L. Harris Professor at GMU) joins Steve and Corey for a wide-ranging discussion. Are books just for advertising? Have blogs peaked? Are podcasts the future or just a bubble? Is technological change slowing? Is there less political correctness in China than the US? Tyler's new book, an apologia for big business, inspires a discussion of CEO pay and changing public attitudes toward socialism. They investigate connections between populism, stagnant wage growth, income inequality and immigration. Finally, they discuss the future global order and trajectories of the US, EU, China, and Russia.

Transcript

Personal Website

Marginal Revolution (Blog)

Conversations with Tyler (Podcast)

Tyler Cowen | Bloomberg Opinion Columnist

Big Business: A Love Letter to an American Anti-Hero (Book)


man·i·fold /ˈmanəˌfōld/ many and various.

In mathematics, a manifold is a topological space that locally resembles Euclidean space near each point.

Steve Hsu and Corey Washington have been friends for almost 30 years, and between them hold PhDs in Neuroscience, Philosophy, and Theoretical Physics. Join them for wide ranging and unfiltered conversations with leading writers, scientists, technologists, academics, entrepreneurs, investors, and more.

Steve Hsu is VP for Research and Professor of Theoretical Physics at Michigan State University. He is also a researcher in computational genomics and founder of several Silicon Valley startups, ranging from information security to biotech. Educated at Caltech and Berkeley, he was a Harvard Junior Fellow and held faculty positions at Yale and the University of Oregon before joining MSU.

Corey Washington is Director of Analytics in the Office of Research and Innovation at Michigan State University. He was educated at Amherst College and MIT before receiving a PhD in Philosophy from Stanford and a PhD in a Neuroscience from Columbia. He held faculty positions at the University Washington and the University of Maryland. Prior to MSU, Corey worked as a biotech consultant and is founder of a medical diagnostics startup.

Risk, Uncertainty, and Heuristics

Risk = space of outcomes and probabilities are known. Uncertainty = probabilities not known, and even space of possibilities may not be known. Heuristic rules are contrasted with algorithms like maximization of expected utility.

See also Bounded Cognition and Risk, Ambiguity, and Decision (Ellsberg).

Here's a well-known 2007 paper by Gigerenzer et al.

Helping Doctors and Patients Make Sense of Health Statistics

Gigerenzer G1, Gaissmaier W2, Kurz-Milcke E2, Schwartz LM3, Woloshin S3.

Many doctors, patients, journalists, and politicians alike do not understand what health statistics mean or draw wrong conclusions without noticing. Collective statistical illiteracy refers to the widespread inability to understand the meaning of numbers. For instance, many citizens are unaware that higher survival rates with cancer screening do not imply longer life, or that the statement that mammography screening reduces the risk of dying from breast cancer by 25% in fact means that 1 less woman out of 1,000 will die of the disease. We provide evidence that statistical illiteracy (a) is common to patients, journalists, and physicians; (b) is created by nontransparent framing of information that is sometimes an unintentional result of lack of understanding but can also be a result of intentional efforts to manipulate or persuade people; and (c) can have serious consequences for health. The causes of statistical illiteracy should not be attributed to cognitive biases alone, but to the emotional nature of the doctor-patient relationship and conflicts of interest in the healthcare system. The classic doctor-patient relation is based on (the physician's) paternalism and (the patient's) trust in authority, which make statistical literacy seem unnecessary; so does the traditional combination of determinism (physicians who seek causes, not chances) and the illusion of certainty (patients who seek certainty when there is none). We show that information pamphlets, Web sites, leaflets distributed to doctors by the pharmaceutical industry, and even medical journals often report evidence in nontransparent forms that suggest big benefits of featured interventions and small harms. Without understanding the numbers involved, the public is susceptible to political and commercial manipulation of their anxieties and hopes, which undermines the goals of informed consent and shared decision making. What can be done? We discuss the importance of teaching statistical thinking and transparent representations in primary and secondary education as well as in medical school. Yet this requires familiarizing children early on with the concept of probability and teaching statistical literacy as the art of solving real-world problems rather than applying formulas to toy problems about coins and dice. A major precondition for statistical literacy is transparent risk communication. We recommend using frequency statements instead of single-event probabilities, absolute risks instead of relative risks, mortality rates instead of survival rates, and natural frequencies instead of conditional probabilities. Psychological research on transparent visual and numerical forms of risk communication, as well as training of physicians in their use, is called for. Statistical literacy is a necessary precondition for an educated citizenship in a technological democracy. Understanding risks and asking critical questions can also shape the emotional climate in a society so that hopes and anxieties are no longer as easily manipulated from outside and citizens can develop a better-informed and more relaxed attitude toward their health.

Tyler Cowen on Efficient Markets (video)

Tyler Cowen explains the basics of the Efficient Market Hypothesis. For a deeper exploration, see Tyler Cowen and rationality, which links to his paper How economists think about rationality.

Tyler Cowen and rationality [my comments]: ... The excerpt below deals with rationality in finance theory and strong and weak versions of efficient markets. I believe the weak version; the strong version is nonsense. (See, e.g, here for a discussion of limits to arbitrage that permit long lasting financial bubbles. In other words, capital markets are demonstrably far from perfect, as defined below by Cowen.)

Although you might think the strong version of EMH is only important to traders and finance specialists, it is also very much related to the idea that markets are good optimizers of resource allocation for society. Do markets accurately reflect the "fundamental value of corporations"? See related discussion here.

...

As you can tell from my comments, I do not believe there is any unique basis for "rationality" in economics. Humans are flawed information processing units produced by the random vagaries of evolution. Not only are we different from each other, but these differences arise both from genes and the individual paths taken through life. Can a complex system comprised of such creatures be modeled through simple equations describing a few coarse grained variables? In some rare cases, perhaps yes, but in most cases, I would guess no. Finance theory already adopts this perspective in insisting on a stochastic (random) component in any model of security prices. Over sufficiently long timescales even the properties of the random component are not constant! (Hence, stochastic volatility, etc.)

Jonathan Haidt and Tyler Cowen

Highly recommended: a great conversation (transcript) between Tyler Cowen and NYU psychology professor Johnathan Haidt. More Haidt.

The transformation of the Academy and the two universities:

COWEN: But is it at least possibly the case that we’re seeing the greatest threat to intellectual diversity in some of the areas which matter least, and when the stakes are high we overcome it. Physics looks pretty good, computer science looks pretty good.

HAIDT: No, it’s not — there are two universities now, but it’s not which ones matter more and which ones matter less. It’s what is the sacred value. The sacred value of universities from sometime in the 19th century through maybe the 1980s was truth. Now it was not perfect, but we all talked that way. Look at the mottos of Harvard and Yale — Veritas, Lux et Veritas, it’s right there on the motto, veritas, truth.

We made a big show — it was largely true — of saying this is what we’re here for, we’re here to find truth. But in the 1970s and ’80s as we had a big influx of baby boomers who were involved in social protest, who were fighting for very good causes, civil rights, women’s rights — they flood into the academy in ’70s and ’80s, they get tenure in the ’80s and ’90s, but also in the 1990s, the Greatest Generation begins to retire. There were a lot of Republicans who became professors after World War II.

But the ’90s is the decade where everything flips. At the start of the 1990s, the overall left‑right ratio of the academy, taking all departments, was two to one, just twice as many people on the left as right. That’s fine, that’s not a problem. But by 2005, it had gone to five to one, five people on the left for every one on the right. Those people on the right are mostly engineering, nursing, things like that. If you look at the core — the humanities and the social sciences, other than economics, it’s closer to 10 to 1 or 20 to 1.

In other words, right‑wing, or libertarian, or social conservative voices have basically vanished between 1995 and 2005. This has made us unfunctional, but it’s in the social sciences and humanities where the sacred value has become social justice and the protection of victims. That’s the division. One university of the sciences still pursues truth, the other university in the social sciences and humanities pursues social justice.

The Replication Crisis (see also One funeral at a time?):

HAIDT: ... I think Brian Nosek, who’s been leading the charge on the problems in psychology, is largely right. That our methods have been sloppy, which has allowed us to engage in practices where we’re just more likely than we should be to get a significant result. And then of course, that’s more likely to get published.

Given that we find the same problem in cancer research and biomedical research — in almost every field where it’s been looked at — I think that the replication crisis is very real. It should be a top priority for science.

A lot of my work is on how we are not fully rational creatures. We are deeply emotional and tribal creatures. If you have this idealized view of researchers and our null hypothesis significant testing is based on idealized view of researchers who are basically testing samples honestly.

“Well, this could only happen 1 in 20 times by chance,” but we’re not those creatures. We want certain outcomes to happen. We make certain choices unconsciously. We all have to up our game. I don’t think there’s anything special about social psychology. It’s no worse than other fields. But we have been the leaders at actually addressing it, and saying, “Why are we not able to replicate each other’s work so much?”

I actually am impressed that the young generation has really embraced this and simply committing to making your data available — if you know that other people are going to get access to your SPSS file, or whatever, your data file, and they’re going to be looking it over, boy, you’re going to be a lot more careful.

I think just by raising the crisis, raising the alarm last year, the quality of our work is going to go substantially up. I’m really excited by this.

Social Psychology IS worse than some other fields, when it comes to reproducibility. First, it is in the wrong (SJW) part of the two universities Haidt describes in the earlier excerpt. Secondly, along with biomedical research, it is in the part of the university where most researchers lack a deep understanding of statistics and quantitative inference. See What is medicine's 5 sigma?

Who's on the other side of the trade?

A great conversation between Tyler Cowen and fund manager Cliff Asness, who has appeared many times on this blog. See, e.g., this 2004 post on his analysis of the well known Fed Model for equity valuation, also discussed in the interview.

Hedge-fund manager Cliff Asness, one of the most influential—and outspoken—financial thinkers, will join Tyler Cowen for a wide-ranging intellectual dialogue as part of the Conversations with Tyler series.

Asness is a founder, managing principal and chief investment officer at AQR Capital Management. In 2012, he was included in the 50 Most Influential list of Bloomberg Markets magazine. As an entrepreneur in the field of finance, Asness has helped shape the national conversation on financial markets and regulation.

He is an active researcher and has authored articles on a variety of financial topics for many publications, including The Journal of Portfolio Management, Financial Analysts Journal, and The Journal of Finance. Prior to cofounding AQR Capital Management, he was a managing director and director of quantitative research for the Asset Management Division of Goldman, Sachs & Co. He is on the editorial board of The Journal of Portfolio Management, the governing board of the Courant Institute of Mathematical Finance at NYU, the board of directors of the Q-Group and the board of the International Rescue Committee.

Milnor, Nash, and Game Theory at RAND

Nash and Milnor were involved in experimental tests of n-person game theory at RAND in 1952. Even then it was clear that game theory had little direct applicability in the real world. See also What Use Is Game Theory? , Iterated Prisoner's Dilemma is an Ultimatum Game, and, e.g., The Econ Con or Venn Diagram for Economics.

A Beautiful Mind: ... For the designers of the experiment[s], however, the results merely cast doubt on the predictive power of game theory and undermined whatever confidence they still had in the subject. Milnor was particularly disillusioned. Though he continued at RAND as a consultant for another decade, he lost interest in mathematical models of social interaction, concluding that they were not likely to evolve to a useful or intellectually satisfying stage in the foreseeable future. The strong assumptions of rationality on which both the work of von Neumann and Nash were constructed struck him as particularly fatal. After Nash won the Nobel Prize in 1994, Milnor wrote an essay on Nash's mathematical work in which he essentially adopted the widespread view among pure mathematicians that Nash's work on game theory was trivial compared with his subsequent work in pure mathematics.

In the essay, Milnor writes:

As with any theory which constructs a mathematical model for some real-life problem, we must ask how realistic the model is. Does it help us to understand the real world? Does it make predictions which can be tested?...

First let us ask about the realism of the underlying model. The hypothesis is that all of the players are rational, that they understand the precise rules of the game, and that they have complete information about the objectives of all of the other players. Clearly, this is seldom completely true.

One point which should particularly be noticed is the linearity hypothesis in Nash's theorem. This is a direct application of the von Neumann-Morgenstern theory of numerical utility; the claim that it is possible to measure the relative desirability of different possible outcomes by a real-valued function which is linear with respect to probabilities .... My own belief is that this is quite reasonable as a normative theory, but that it may not be realistic as a descriptive theory.

Evidently, Nash's theory was not a finished answer to the problem of understanding competitive situations. In fact, it should be emphasized that no simple mathematical theory can provide a complete answer, since the psychology of the players and the mechanism of their interaction may be crucial to a more precise understanding.

For more discussion, including specific experimental results, see Machine Dreams, chapter 6.2: It's a world eat world dog: game theory at RAND.

Becoming a behaviorialist

Becoming a behaviorialist (i.e., overcoming autism in economics ;-). Audio interview.

Leading behavioral economist Richard Thaler, the Ralph and Dorothy Keller Distinguished Service Professor of Behavioral Science and Economics, talks about how he found his way into this then-nonexistent field and how he came to study irrational economic behavior at UChicago, the home of efficient markets and rational expectations.

Lots of other good interviews in this Chicago series (iTunes): Heckman, Sargent on the euro, Hansen on risk.

Looking back at the credit crisis

I thought it worthwhile to re-post my 2008 slides on the credit crisis. I wrote these slides just as the crisis was getting started (right after the big defaults), but I still think my analysis was correct and better than post-hoc discussions that are going on to this day.

I believe I called the housing bubble back in 2004 -- see, e.g., here for a specific discussion of bubbles and timescales. The figure above also first appeared on my blog in 2004 or 2005.

(2004) ... The current housing bubble is an even more egregious example. Because real estate is not a very liquid investment - the typical family has to move and perhaps change jobs to adjust to mispricing - the timescale for popping a bubble is probably 5-10 years or more. Further, I am not aware of any instruments that let you short a real estate bubble in an efficient way.

I discussed the risks from credit derivatives as early as 2005; see also here and here.

Finally, there was a lot of post-crisis discussion on this blog and elsewhere about mark to market accounting: were CDO, CDS oversold in the wake of the crisis (see also The time to buy is when there is blood in the streets; if you want to know what "leading experts" were saying in 2008, see the Yale SOM discussion here -- oops, too embarrassing, maybe they took it down ;-), or was Mr. Market still to be trusted in the worst stages of a collapse? The answer is now clear; even Fannie and Freddie have returned $180 billion to the Feds!

EMH vs Macro, Fischer Black

Arnold Kling on the tension between macroeconomics and the Efficient Markets Hypothesis (EMH). I'm surprised this isn't more often noticed by economists. But I suppose macro types don't tend to think deeply about finance (at least, not before the recent crisis; how many macro types actually understand Black-Scholes-Merton?) and vice versa. I was shocked at the beginning of the credit crisis to meet famous macroeconomists who didn't know what a credit default swap was, and I still often meet finance types who laugh at macro models.

askblog: Consider financial variables, such as the long-term interest rate or the price-earnings ratio of the overall stock market. According to the efficient markets hypothesis, these are not predictable on the basis of known information. To put this another way, you cannot beat the market forecast for these variables.

On the other hand, in conventional macroeconomics these variables can be predicted using models and controlled using policy levers. Reconciling this with the EMH has challenged economists for decades. ...

I prefer a third way of looking at things, which might be expressed in the work by Frydman and Goldberg. That is, there is no reason for all participants in markets to be using the same model. They have different information sets. The EMH is a useful guide to everyone, because it serves as a reminder that it is unwise to assume that your information set is somehow superior. However, it is not correct to impose “rational expectations,” in which everyone uses the same model.

... Incidentally, I recently re-read Perry Mehrling’s biography of Fischer Black. Black was perhaps the first economist to think about the contrast between modern finance theory and conventional macro, and Black was the first and perhaps the only one to attempt to recast macro entirely in terms of modern finance.

More thoughts on EMH here. My comments on Mehrling's bio and Fischer Black are here.

... on the topic of finance books, I highly recommend this biography of Fischer Black, which I should have reviewed here long ago. Fischer was yet another outsider (his background was in theoretical physics) to finance who made an important contribution. Unlike Kelly, he was accorded mainstream recognition (professorship at Chicago and partnership at Goldman) during his career. The most impressive thing about Black was his ability to think deeply and independently -- beyond the conventional wisdom. There are some very intriguing passages in the book about his views on money and banking which are, I think, quite unconventional to mainstream economics.

... Black was both an undergrad and grad student at Harvard in physics. He didn't really complete his PhD in physics, but sort of drifted into AI-related stuff(!) at MIT, under cover of math or applied math.

The bio says the only course he ever had trouble with was Schwinger's course on advanced quantum. The biographer suggests Black did poorly due to lack of interest, but I find that hard to believe given the subject matter, the lecturer and the times ;-)

Black's point of view was clearly that of a physicist or applied mathematician. He really was a fascinating guy, and the biographer, being an academic economist, can appreciate a lot of Black's thinking -- it's not an entirely superficial book despite being non-technical.

After reading the book, I don't feel so bad about questioning some of the fundamental assumptions made by academic economists. Black was asking some of the very same questions during his career.

Akerloff on Efficient Markets Hypothesis

I particularly like his comments (@13 min or so) on Snake Oil and financial assets. When market participants are exuberant (overly confident) it is natural for firms to create and market new assets that are overpriced relative to actual value, or have dangerous risk-return tradeoffs. For the latest example, in natural gas drilling rights during the recent boom (now a bust), see here.

See also Venn diagram for economics.

The cover illustration of Akerloff and Shiller's book. Are there any economists outside of Chicago who still don't believe in "animal spirits"?

The truth about venture capital

The excerpt below is from the Kauffman Foundation's report on venture investing. I'd like to see a similar report for hedge and private equity funds. If you believe in efficient markets and rational sophisticated investors (i.e., pension funds, endowments, the super wealthy), you have to explain why they continue to invest in underperforming asset classes and pay exorbitant fees. My explanation is that apes are not smart. Alpha is hard to detect and it's easier to believe a story (narrative sales pitch) than the numbers (esp. if the numbers are hard to obtain or require a bit of brainpower to interpret). Financial services are incorrectly priced, both by sophisticated investors, and by society. Via Ben Lorica.

EXECUTIVE SUMMARY 

Venture capital (VC) has delivered poor returns for more than a decade. VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC. Speculation among industry insiders is that the VC model is broken, despite occasional high-profile successes like Groupon, Zynga, LinkedIn, and Facebook in recent years. 

The Kauffman Foundation investment team analyzed our twenty-year history of venture investing experience in nearly 100 VC funds with some of the most notable and exclusive partnership “brands” and concluded that the Limited Partner (LP) investment model is broken. Limited Partners—foundations, endowments, and state pension fund—invest too much capital in underperforming venture capital funds on frequently mis-aligned terms. 

Our research suggests that investors like us succumb time and again to narrative fallacies, a well-studied behavioral finance bias. We found in our own portfolio that: 

 Only twenty of 100 venture funds generated returns that beat a public-market equivalent by more than 3 percent annually, and half of those began investing prior to 1995.

 The majority of funds—sixty-two out of 100—failed to exceed returns available from the public markets, after fees and carry were paid. 

 There is not consistent evidence of a J-curve in venture investing since 1997; the typical Kauffman Foundation venture fund reported peak internal rates of return (IRRs) and investment multiples early in a fund’s life (while still in the typical sixty-month investment period), followed by serial fundraising in month twenty-seven. 

 Only four of thirty venture capital funds with committed capital of more than $400 million delivered returns better than those available from a publicly traded small cap common stock index. 

 Of eighty-eight venture funds in our sample, sixty-six failed to deliver expected venture rates of return in the first twenty-seven months (prior to serial fundraises). The cumulative effect of fees, carry, and the uneven nature of venture investing ultimately left us with sixty-nine funds (78 percent) that did not achieve returns sufficient to reward us for patient, expensive, longterm investing. 

Investment committees and trustees should shoulder blame for the broken LP investment model, as they have created the conditions for the chronic misallocation of capital. ...

See earlier post How to run a hedge fund.

The illusion of skill

Daniel Kahneman claims that differences in the performance of professional investors are mostly due to luck, whereas compensation is awarded as if differences are due to skill. Most alpha is fake alpha.

This of course raises all sorts of questions about why such people are allowed to become so extravagantly wealthy. The usual argument is that their investment decisions lead to more efficient resource allocation in the economy. (They are a "necessary evil" of a capitalist market system that benefits all of us :-) But if the decisions of the highest paid professionals are no better than those of average professionals, we could replace the services of the highest earners at much lower cost (or cap their salaries or impose high marginal tax rates) without negatively impacting the overall quality of decisions or the efficiency of the economy.








The article is worth reading in its entirety.

NYTimes: ... No one in the firm seemed to be aware of the nature of the game that its stock pickers were playing. The advisers themselves felt they were competent professionals performing a task that was difficult but not impossible, and their superiors agreed. On the evening before the seminar, Richard Thaler and I had dinner with some of the top executives of the firm, the people who decide on the size of bonuses. We asked them to guess the year-to-year correlation in the rankings of individual advisers. They thought they knew what was coming and smiled as they said, “not very high” or “performance certainly fluctuates.” It quickly became clear, however, that no one expected the average correlation to be zero.

What we told the directors of the firm was that, at least when it came to building portfolios, the firm was rewarding luck as if it were skill. This should have been shocking news to them, but it was not. There was no sign that they disbelieved us. How could they? After all, we had analyzed their own results, and they were certainly sophisticated enough to appreciate their implications, which we politely refrained from spelling out. We all went on calmly with our dinner, and I am quite sure that both our findings and their implications were quickly swept under the rug and that life in the firm went on just as before. The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry. Facts that challenge such basic assumptions — and thereby threaten people’s livelihood and self-esteem — are simply not absorbed. The mind does not digest them. This is particularly true of statistical studies of performance, which provide general facts that people will ignore if they conflict with their personal experience.

The next morning, we reported the findings to the advisers, and their response was equally bland. Their personal experience of exercising careful professional judgment on complex problems was far more compelling to them than an obscure statistical result. When we were done, one executive I dined with the previous evening drove me to the airport. He told me, with a trace of defensiveness, “I have done very well for the firm, and no one can take that away from me.” I smiled and said nothing. But I thought, privately: Well, I took it away from you this morning. If your success was due mostly to chance, how much credit are you entitled to take for it?

From the comments.

If you read the whole article, you see that Kahneman does believe in skill. For example, his studies show that some doctors are better at diagnosis than others. I am also sure that some entrepreneurs or some physicists or some athletes are better than others. (Although in the case of entrepreneurs it would be very hard to demonstrate statistically since outcomes are noisy and the number of attempts per entrepreneur is relatively small.)

But there may be areas where *the differences between high level professionals* (e.g., people who have been hired to run money, have top MBAs or graduate degrees, etc.) are statistically seen to be mostly due to luck. This has already been convincingly demonstrated for pundits or analysts of complex world events by Tetlock's studies of expertise. (You can find several posts on this blog on the topic.) Whether it's true of money managers (or even big company CEOs) is controversial. If you argue the skill side, I'd like to see *your* statistical evidence, not just repetition of your priors (again and again).

Expert predictions

In all areas of human activity, even the skill dominated ones, luck plays a big factor. This is a good argument for redistribution -- almost every successful person owes some of their success to luck.

and

It seems to me that the 20th century trend in democracies is toward greater redistribution: social safety nets, guaranteed minimum income, etc. People have been conditioned to believe these are aspects of a just society.

The question is: what is the optimum level of redistribution? (Given a particular utility function for society.)

One argument is that we have to let the rich get rich in order to have strong economic growth. Too much redistribution means a smaller pie to split. But the Illusion of Skill argument (if correct) suggests that for some activities like finance a high marginal tax rate (say, which kicks in above the income of the *average* finance professional; this would then only affect the top earning financiers who, according to the argument are not adding any real value that the average guys can't also provide) would not negatively affect economic efficiency.

If people irrationally and incorrectly believe that only Harvard MDs are capable of treating pneumonia, and bid up their compensation to exorbitant levels (levels so high that the Harvard MDs begin exerting financial and political control over society as a whole), wouldn't it be better for society to impose a high tax rate on Harvard MDs, which kicks in above the income of other doctors with similar credentials (but who are not beneficiaries of the irrational belief)?

Incentives matter, but what kind?

Monetary incentives work for simple, mechanical tasks, but not so well for cognitively loaded tasks.

Once monetary compensation is high enough that people can turn their attention to the work, additional compensation (or emphasis on compensation) can actually have negative consequences. What really elicits good performance: autonomy, mastery and purpose.

What use is game theory?

Fantastic interview with game theorist Ariel Rubinstein on Econtalk. I agree with Rubinstein that game theory has little predictive power in the real world, despite the pretty mathematics. Experiments at RAND (see, e.g., Mirowski's Machine Dreams) showed early game theorists, including Nash, that people don't conform to the idealizations in their models. But this wasn't emphasized (Mirowski would claim it was deliberately hushed up) until more and more experiments showed similar results. (Who woulda thought -- people are "irrational"! :-)

Perhaps the most useful thing about game theory is that it requires you to think carefully about decision problems. The discipline of this kind of analysis is valuable, even if the models have limited applicability to real situations.

Rubinstein discusses a number of topics, including raw intelligence vs psychological insight and its importance in economics (see also here). He has, in my opinion, a very developed and mature view of what social scientists actually do, as opposed to what they claim to do.

Rubinstein reminds me strongly (in intellectual style, manner of speaking) of other great Israeli academics I have known. Such people are a treasure.

Ariel Rubinstein of Tel Aviv University and New York University talks with EconTalk host Russ Roberts about the state of game theory and behavioral economics, two of the most influential areas of economics in recent years. Drawing on his Afterword for the 60th anniversary edition of Von Neumann and Morgenstern's Theory of Games and Economic Behavior, Rubinstein argues that game theory's successes have been quite limited. Rubinstein, himself a game theorist, argues that game theory is unable to yield testable predictions or solutions to public policy problems. He argues that game theorists have a natural incentive to exaggerate its usefulness. In the area of behavioral economics, Rubinstein argues that the experimental results (which often draw on game theory) are too often done in ways that are not rigorous. The conversation concludes with a plea for honesty about what economics can and cannot do.

Here is Rubinstein's Afterward to the 60th anniversary edition of Theory of Games. It is only a few pages and definitely worth reading if you have any interest in game theory, or if you are pressed for time and can't listen to the podcast. See p. 634:

So is game theory useful in any way? The popular literature is full of nonsensical claims to that effect [Remember the FCC bandwidth auctions?] ... Most situations can be analyzed in a number of ways, which usually yield contradictory "predictions" ...

See also Venn diagram for economics :-)

Note Added: Ariel Rubinstein found this post and sent me a nice email with a link to this photo album of cafes around the world where he likes to work. Below is one of the places I've actually been to (Brewed Awakening in Berkeley). I guess academics should not complain about our lot in life :-)

Buy high, sell low

A contrarian strategy ("the average investor is stupid") would have paid off pretty well over the last decade. Ah, the wisdom of markets :-)

WSJ: [A recent research report] calculates that mutual fund investors [over the last decade] bought into the Standard & Poor's 500-stock index at an average of 1,434. That's close to its record high of 1,565. If investors had invested at random times instead, their average purchase price would have been 1,171. [Note an actual contrarian strategy would have performed better than random buying.]

... Human beings are hard-wired to run with the herd. For millions of years, when the herd stampeded, the smartest move wasn't the hang around and wait to see why. It was to run.

And that's how they act on the stock market as well. But when it comes to investing, it's a bad idea. Your feelings are a bad guide. And there is no safety in numbers.

I am frequently surprised at how many people still give in to their instincts in these matters. During the housing boom, anything I wrote questioning house prices automatically drew scathing reactions. ...

Coordinating mediocrity

Seth Roberts (a psychology professor who splits his time between Berkeley and Tsinghua in Beijing) points me to an interesting paper by two Italian sociologists.

If you speak to young Italians, particularly scientists and other highly educated people, you will hear terrible stories about just how dysfunctional their academic and research systems have become. At meetings like the one I am currently attending, I often hear the comment that Italy's number one export is talented people, trained at the expense of taxpayers. "Look at all the Italians at this conference -- but they are all working in other countries!"

The paper characterizes the current situation in Italy as a collective outcome (equilibrium) with its own cynical and corrosive social norms. I can easily think of other examples! There is tremendous value to being an efficient "high trust" society (what the authors would call an H-world), and once the equilibrium has shifted in the L direction it is very hard to correct.

One very jarring thing about science and academia is that students entering the field are among the most idealistic of people, yet a significant fraction of senior researchers are among the most cynical. The proportions vary by discipline.

L-worlds: the curious preference for low quality and its norms

Diego Gambetta and Gloria Origgi
Department of Sociology, Oxford University

Abstract. We investigate a phenomenon which we have experienced as common when dealing with an assortment of Italian public and private institutions: people promise to exchange high quality goods and services (H), but then something goes wrong and the quality delivered is lower than promised (L). While this is perceived as ‘cheating’ by outsiders, insiders seem not only to adapt but to rely on this outcome. They do not resent low quality exchanges, in fact they seem to resent high quality ones, and are inclined to ostracise and avoid dealing with agents who deliver high quality. This equilibrium violates the standard preference ranking associated to the prisoner’s dilemma and similar games, whereby self-interested rational agents prefer to dish out low quality in exchange for high quality. While equally ‘lazy’, agents in our L-worlds are nonetheless oddly ‘pro-social’: to the advantage of maximizing their raw self-interest, they prefer to receive low quality provided that they too can in exchange deliver low quality without embarrassment. They develop a set of oblique social norms to sustain their preferred equilibrium when threatened by intrusions of high quality. We argue that cooperation is not always for the better: high quality collective outcomes are not only endangered by self-interested individual defectors, but by ‘cartels’ of mutually satisfied mediocrities.

Here is a nice example:

... When Federico Varese (1996) revealed that Stefano Zamagni, a well-established Italian economist, had plagiarised verbatim several pages from Robert Nozick, Varese was criticised by several Italian colleagues who together evoked nine norms or reasons that he would have violated by blowing the whistle. None of these include a justification of plagiarism per se. Varese discusses them in an unpublished article (“Economia d’idee II”). They are worth listing, their range is staggering:

1. There is nothing original, everyone plagiarises, so why bother? [journalist]

2. Whistle blowers are always worse than their targets [sociologist]

3. What is the point of targeting Zamagni? They will never punish him anyway.

4. What is the point of blowing the whistle as you will pay the consequences

5. He is a good “barone”, much better than many others, so why target him?

6. Zamagni is a member of the left and you should not weaken the left during election times [economist; various friends]

7. Zamagni shows good intellectual tastes as he plagiarises very good authors, so he does not deserve to be attacked [philosopher]

8. Given that many are guilty of plagiarism, targeting one in particular shows that the whistle blower is driven by base motives.

9. In addition, an economist suggested an explanation rather than a justification saying that the real author of the plagiarism was probably a student of Zamagni who wrote the paper for him. This would, funnily enough, imply that Zamagni was innocent of the plagiarism, but still that he signed a paper he did not write, written by someone who also did not write it!

From the conclusions:

... Whatever its origins, the cost of the L-propensity is proving over time more detrimental than helpful – flexibility shifts to laxness, tolerance to sloppiness, and confusion to breaches of trust – and standards in Italian education, politics, media and cultural creativity in general, although blessed by the occasional geniuses, have never risen and have quite possibly declined further. One does not need to be an incurable perfectionist to appreciate how sadly this is the case.

An implication of this paper is that the threat to good collective outcomes is not just free-riding. There are subtler ones. The L-world we described is not an extra-normative one populated by isolate individual predators free to roam around, but one governed by its own ‘perverse’ social norms. The social sciences have focused on cooperation and on the social norms that sustain it while narrowly conceiving of anti-cooperators as individualistic predators, acting free of normative constraints. Social norms, in the dominant interpretation, would exist as an antidote to our natural antisocial proclivities. The interest of our case is to suggest that this distinction does not stand up, and that those whom we think of as free-riders too operate within a normative structure – a special “cement of society” that glues L-doers together to the detriment of the common good.

See also footnote 3:

Recent experimental research carried out by Herrmann, Thöni & Gächter (2007) has come up with unexpected evidence which may be germane to our case. They ran the so called public-good game with university students in 15 cities in the developed and developing world, from the US to China, from the UK to Russia, Turkey and Saudi Arabia. ... In other words, there were some L-doers who punish H-doers. ... Going in descending order of size of punishment, punishment of more generous contributors was found in Muscat, Athens, Riyadh, Samara, Minsk, Istanbul, Seoul and Dnipropetrovs'k. Although not entirely absent, this type of punishment proved negligible in Boston, Nottingham, St. Gallen, Zurich, Copenhagen, Bonn, and Chengdu.

Volcker: time is growing short

There's more about trade and fiscal balances, etc., but I thought the following was particularly good.

NY Review of Books: ... I think it is fair to say that for some time the dominant approach of economic theorizing, increasingly reflected in public policy, has been that free and open financial markets, supported by advances in electronic technology and by sophisticated financial engineering, would most effectively support both market efficiency and stability. Without heavily intrusive regulation, investable funds would flow to the most profitable and productive uses. The inherent risks of making loans and extending credits would be diffused and reallocated among those best able and willing to bear them.

It is an attractive thesis, attractive not only in concept but for those participating in its seeming ability to generate enormous financial rewards. Our best business schools developed and taught ever more complicated models. A large share of the nation’s best young talent was attracted to finance. However, even when developments seemed most benign, there were warning signs.

Has the contribution of the modern world of finance to economic growth become so critical as to support remuneration to its participants beyond any earlier experience and expectations? Does the past profitability of and the value added by the financial industry really now justify profits amounting to as much as 35 to 40 percent of all profits by all US corporations? Can the truly enormous rise in the use of derivatives, complicated options, and highly structured financial instruments really have made a parallel contribution to economic efficiency? If so, does analysis of economic growth and productivity over the past decade or so indicate visible acceleration of growth or benefits flowing down to the average American worker who even before the crisis had enjoyed no increase in real income?

There was one great growth industry. Private debt relative to GDP nearly tripled in thirty years. Credit default swaps, invented little more than a decade ago, soared at their peak to a $60 trillion market, exceeding by a large multiple the amount of the underlying credits potentially hedged against default. Add to those specifics the opacity that accompanied the enormous complexity of such transactions.

The nature and depth of the financial crisis is forcing us to reconsider some of the basic tenets of financial theory. To my way of thinking, that is both necessary and promising in pointing toward useful reform.

One basic flaw running through much of the recent financial innovation is that thinking embedded in mathematics and physics could be directly adapted to markets. A search for repetitive patterns of behavior and computations of normal distribution curves are a big part of the physical sciences. However, financial markets are not driven by changes in natural forces but by human phenomena, with all their implications for herd behavior, for wide swings in emotion, and for political intervention and uncertainties. ...

Posner: How I became a Keynesian

Somehow I missed this! Thanks to a reader for pointing it out to me.

Posner was as captured by Chicago School nonsense as anyone else, but at least we learn that he can perform a Bayesian update (i.e., learn from reality) -- posteriors need not be wholly determined by priors :-)

Strangely, I don't see any discussion of this article on the Becker-Posner blog. How do Gary Becker and Robert Lucas feel about the recent apostasy of their colleague?

How I Became a Keynesian, by Richard Posner

... I had never thought to read The General Theory of Employment, Interest, and Money, despite my interest in economics.

... We have learned since September that the present generation of economists has not figured out how the economy works. The vast majority of them were blindsided by the housing bubble and the ensuing banking crisis; and misjudged the gravity of the economic downturn that resulted; and were perplexed by the inability of orthodox monetary policy administered by the Federal Reserve to prevent such a steep downturn; and could not agree on what, if anything, the government should do to halt it and put the economy on the road to recovery. By now a majority of economists are in general agreement with the Obama administration's exceedingly Keynesian strategy for digging the economy out of its deep hole.

... The dominant conception of economics today, and one that has guided my own academic work in the economics of law, is that economics is the study of rational choice. People are assumed to make rational decisions across the entire range of human choice, including but not limited to market transactions, by employing a form (usually truncated and informal) of cost-benefit analysis. The older view was that economics is the study of the economy, employing whatever assumptions seem realistic and whatever analytical methods come to hand. Keynes wanted to be realistic about decision-making rather than explore how far an economist could get by assuming that people really do base decisions on some approximation to cost-benefit analysis.

... It is an especially difficult read for present-day academic economists, because it is based on a conception of economics remote from theirs. This is what made the book seem "outdated" to Mankiw--and has made it, indeed, a largely unread classic. (Another very distinguished macroeconomist, Robert Lucas, writing a few years after Mankiw, dismissed The General Theory as "an ideological event.") The dominant conception of economics today, and one that has guided my own academic work in the economics of law, is that economics is the study of rational choice. People are assumed to make rational decisions across the entire range of human choice, including but not limited to market transactions, by employing a form (usually truncated and informal) of cost-benefit analysis. The older view was that economics is the study of the economy, employing whatever assumptions seem realistic and whatever analytical methods come to hand. Keynes wanted to be realistic about decision-making rather than explore how far an economist could get by assuming that people really do base decisions on some approximation to cost-benefit analysis.

The General Theory is full of interesting psychological observations--the word "psychological" is ubiquitous--as when Keynes notes that "during a boom the popular estimation of [risk] is apt to become unusually and imprudently low," while during a bust the "animal spirits" of entrepreneurs droop. He uses such insights without trying to fit them into a model of rational decision-making.

An eclectic approach to economic behavior came naturally to Keynes, because he was not an academic economist in the modern sense. He had no degree in economics, and wrote extensively in other fields (such as probability theory--on which he wrote a treatise that does not mention economics). He combined a fellowship at Cambridge with extensive government service as an adviser and high-level civil servant, and was an active speculator, polemicist, and journalist. He lived in the company of writers and was an ardent balletomane.

... The third claim that I am calling foundational for Keynes's theory--that the business environment is marked by uncertainty in the sense of risk that cannot be calculated--now enters the picture. Savers do not direct how their savings will be used by entrepreneurs; entrepreneurs do, guided by the hope of making profits. But when an investment project will take years to complete before it begins to generate a profit, its prospects for success will be shadowed by all sorts of unpredictable contingencies, having to do with costs, consumer preferences, actions by competitors, government policy, and economic conditions generally. Skidelsky puts this well in his new book: "An unmanaged capitalist economy is inherently unstable. Neither profit expectations nor the rate of interest are solidly anchored in the underlying forces of productivity and thrift. They are driven by uncertain and fluctuating expectations about the future." Only what Keynes called "animal spirits," or the "urge to action," will persuade businessmen to embark on such a sea of uncertainty. "If human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation."

But however high-spirited a businessman may be, often the uncertainty of the business environment will make him reluctant to invest. His reluctance will be all the greater if savers are hesitant to part with their money because of their own uncertainties about future interest rates, default risks, and possible emergency needs for cash to pay off debts or to meet unexpected expenses. The greater the propensity to hoard, the higher the interest rate that a businessman will have to pay for the capital that he requires for investment. And since interest expense is greater the longer a loan is outstanding, a high interest rate will have an especially dampening effect on projects that, being intended to meet consumption needs beyond the immediate future, take a long time to complete.

... An ambitious public-works program can be a confidence builder. It shows that government means (to help) business. "The return of confidence," Keynes explains, "is the aspect of the slump which bankers and businessmen have been right in emphasizing, and which the economists who have put their faith in a ‘purely monetary' remedy have underestimated." In a possible gesture toward Roosevelt's first inaugural ("we have nothing to fear but fear itself"), Keynes remarks upon "the uncontrollable and disobedient psychology of the business world."

See also my talk (for physicists) on the financial crisis. Some related posts on Keynes. Even more on Keynes (12th Wrangler) here.