Keynes v Hayek

At the beginning of the debate you get to hear a bunch of Brits at the LSE shouting "Yo Keynes!" and "Yo Hayek!" in support of their respective sides. No one seems capable of convincing the other side of anything, but the discussion is entertaining.

Keynes v Hayek

Speaker(s): Professor George Selgin, Professor Lord Skidelsky, Duncan Weldon, Dr Jamie Whyte

Recorded on 26 July 2011.

How do we get out of the financial mess we're in? Two of the great economic thinkers of the 20th century had sharply contrasting views: John Maynard Keynes believed that governments could create sustainable employment and growth. His contemporary and rival Friedrich Hayek believed that investments have to be based on real savings rather than fiscal stimulus or artificially low interest rates.

See also round 2 of the Keynes Hayek rap video:

Bertrand Russell

At the bookstore yesterday I came across the autobiography of Bertrand Russell, which I became engrossed in for some time. Below is the prologue, written when Russell was 84.

WHAT I HAVE LIVED FOR.

Three passions, simple but overwhelmingly strong, have governed my life: the longing for love, the search for knowledge, and unbearable pity for the suffering of mankind. These passions, like great winds, have blown me hither and thither, in a wayward course, over a deep ocean of anguish, reaching to the very verge of despair.

I have sought love, first, because it brings ecstasy -- ecstasy so great that I would often have sacrificed all the rest of life for a few hours of this joy. I have sought it, next, because it relieves loneliness -- that terrible loneliness in which one shivering consciousness looks over the rim of the world into the cold unfathomable lifeless abyss. I have sought it, finally, because in the union of love I have seen, in a mystic miniature, the prefiguring vision of the heaven that saints and poets have imagined. This is what I sought, and though it might seem too good for human life, this is what -- at last -- I have found.

With equal passion I have sought knowledge. I have wished to understand the hearts of men. I have wished to know why the stars shine. And I have tried to apprehend the Pythagorean power by which number holds sway above the flux. A little of this, but not much, I have achieved.

Love and knowledge, so far as they were possible, led upward toward the heavens. But always pity brought me back to earth. Echoes of cries of pain reverberate in my heart. Children in famine, victims tortured by oppressors, helpless old people a hated burden to their sons, and the whole world of loneliness, poverty, and pain make a mockery of what human life should be. I long to alleviate the evil, but I cannot, and I too suffer.

This has been my life. I have found it worth living, and would gladly live it again if the chance were offered me.

I found Russell's comments on Keynes quite interesting.

Keynes's intellect was the sharpest and clearest that I have ever known. When I argued with him, I felt that I took my own life in my hands, and I seldom emerged without feeling something of a fool. I was sometimes inclined to think that so much cleverness must be incompatible with depth, but I do not think this feeling was justified.

The bookstore had quite a nice section of Russell books. He wrote what could be classified as a "self help" book called The Conquest of Happiness, which anticipated a lot of recent work in positive psychology. See here for a nice overview.

... For those who find that even “the exercise of choice is in itself tiresome,” (147) Russell has a remedy that anticipates the smart unconscious. “I have found, for example, that if I have to write upon some rather difficult topic the best plan is to think about it with very great intensity—the greatest intensity of which I am capable—for a few hours or days, and at the end of that time to give orders, so to speak, that the work is to proceed underground. After some months I return consciously to the topic and find that the work has been done.” (49-50)

Perhaps the greatest obstacle to happiness is “the disease of self-absorption.” (173) Russell offers that his own conquest of happiness was due “very largely [. . . ] to a diminishing preoccupation with myself.” (6) A happy person knows that “one’s ego is no very large part of the world.” (48) ...

To the self-absorbed person, other people primarily serve as objects of comparison. “What people fear [. . .] is not that they will fail to get their breakfast next morning, but that they will fail to outshine their neighbors.” (27) Russell warns that “the habit of thinking in terms of comparisons is a fatal one.” (57) To overcome it, “teach yourself that life would still be worth living even if you were not, as of course you are, immeasurably superior to all your friends in virtue and intelligence.” (173) “You can get away from envy by enjoying the pleasures that come your way, by doing the work that you have to do, and by avoiding comparisons with those whom you imagine, perhaps quite falsely, to be more fortunate than yourself.” (58-59)

Likewise, Russell advises not to worry too much about what others think of you. On the one hand, he suspects that “if we were all given by magic the power to read each other’s thoughts, I suppose the first effect would be that almost all friendships would be dissolved.” (76) On the other hand, he doubts that “most people give enough thought to you to have any special desire to persecute you.” (79) This is a nice example of regression to the mean: Chances are you overestimate the love of your friends and the disdain of your foes.

The Chicago School and the financial crisis

New Yorker economics correspondent John Cassidy has a very balanced piece about the impact of the credit crisis on thinking at The Chicago School. He also uses the term apostasy to describe Posner's turn toward Keynes.

In the article, Heckman, Becker and Rajan seem the most reasonable. Fama is obviously clinging to his priors and Lucas refused to talk to Cassidy.

Cassidy makes additional remarks on his blog, and promises in the near future to publish more detailed notes on the interviews he did with the Chicago economists.

... For people interested in the subject, and there seems to be a lot of you, the good news is that I’m planning on posting here much fuller versions of the interviews I did in Chicago, with the likes of Gene Fama, Gary Becker, and Richard Posner, who recently converted to Keynesianism. It’s the nature of long-form magazine journalism that a lot of interesting stuff gets left out of the finished article, but, thanks to the Web, there’s no reason it shouldn’t appear in some form. Plus, I think it’s a good time to let the Chicago economists speak for themselves. Over the last couple of years, they have taken a battering at the hands of myself, Paul Krugman, Joe Stiglitz, and others. Having just finished writing a book entitled “How Markets Fail,” I went to the Windy City eager to learn first hand how the critiques of Chicago economics were being received. Some of what I was told, I don’t agree with, but at this time of intellectual tumult I think it makes fascinating reading.

In the article Posner notes that few economists knew anything about how real financial markets work. This is certainly true in my experience. In particular, they were naive about individual incentives within the system (see Greenspan comments), and very few academics (with perhaps one or two exceptions; video) had any idea what a CDO or CDS was before 2008. I can't resist a little sniping here. If you want to ask someone about electrons, or how to build a quantum logic gate, or how to fabricate nanostructures, you can't do much better than to head to your local research university and talk to a physics professor. Strangely, if I wanted to learn something about credit markets or securitization or the risk from speculative bubbles, I would have been better off talking to a former physicist on Wall St. than to almost any professor in an economics department or business school. I'm not exaggerating -- I've done both many times. Posner also says:

"Well, one possibility is that they [the economists] have learned nothing [from the financial crisis] ... Because -- how should I put it -- because market correctives work very slowly in dealing with academic markets. Professors have tenure. ... It takes a great deal to drive them out of their accustomed way of doing business."

For more, see my talk on the financial crisis.

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.

Skidelsky at LSE

I highly recommend this brilliant LSE lecture by Robert Skidelsky. Among the topics covered: risk versus uncertainty; Chicago school as the academic scribblers responsible for recent disastrous ideological capture; rational expectations, efficient markets and all that nonsense; economics as a science (not) and the role of mathematics; fiscal versus monetary stimulus; Glass-Steagall; Capital ascendant over Labor and Government: the renewed relevance of Marx; the role of globalization and the neoliberal agenda.

Before attacking me as a socialist pinko (I am not), listen to the talk or at least read the earlier post linked to below.

Keynes and the Crisis of Capitalism
(podcast and video available)

Date: Wednesday 7 October 2009
Speaker: Professor Lord Skidelsky

Robert Skidelsky is Emeritus Professor of Political Economy at the University of Warwick. His three-volume biography of the economist John Maynard Keynes (1983, 1992, 2000) received numerous prizes, including the Lionel Gelber Prize for International Relations and the Council on Foreign Relations Prize for International Relations. He is the author of The World After Communism (1995) (American edition called The Road from Serfdom). He was made a life peer in 1991, and was elected Fellow of the British Academy in 1994.

This event celebrates his latest book, Keynes: The Return of the Master.

For more from Skidelsky on Keynes and the current crisis, see this earlier post.

Keynes: ... the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

Krugman: the Economists have no clothes

Only Nixon could go to China, and only Paul Krugman could write this mea culpa for the discipline of economics.

There was a bubble in housing -- everybody knows that now. There was a bubble in finance itself -- the financial share of national income reached an all-time high just before the crisis; not too many people know this. There was even an academic bubble in the field of economics: the perceived quality of results in the field, reflected in the salaries and prestige of economics professors (e.g., relative to other social scientists), was as inflated as the price of any McMansion -- surely every university dean must understand this now? (Bayesian / Machine Learning comment: do these guys ever update? Or is it "All priors, all the time"?)

I suggest reading the whole thing. I've only excerpted the last three paragraphs below. (See also related essay by Richard Posner and this interview with Bill Janeway.)

How Did Economists Get It So Wrong?: ... So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.

Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: “There is always an easy solution to every human problem — neat, plausible and wrong.”

When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly. The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but we can hope that it will have the virtue of being at least partly right.

Related posts on Krugman's article from two thoughtful economists, Brad DeLong: Which economists got it so wrong? , Where does macro go from here? and Arnold Kling: Krugman vs Blanchard.

Keynes

Robert Skidelsky, Keynes' biographer, writes in the Times magazine (excerpted below). Keynes had lived through the greatest of all bubbles and crashes, and saw through the convenient but deeply flawed idea of efficient markets.

As someone with a mathematical bent I was not initially drawn to Keynes' brand of economics -- my interests were in areas of modern finance like option pricing theory, volatility, stochastic models. But like Keynes I have seen a bubble up close -- first in Silicon Valley, and now, from a greater distance, the current credit crisis. What seemed to be reasonable rough approximations: efficient markets, no arbitrage conditions, stochastic processes, etc., have been revealed as terribly naive and dangerous. And so over time my views have come to resemble those described below. (See my talk on the financial crisis, and this Venn diagram.)

Although he is best known as an economist, Keynes' Treatise on Probability, written relatively early in his career, is quite good, and also stresses the idea of probability as a form of logic which goes beyond binary truth values. (See related post on E.T. Jaynes and Bayesian thinking.)

Note to commenters: I am not endorsing all "Keynsian" policy measures. I am endorsing Keynes' opinions on efficient markets, risk and the importance of psychological and sociological factors in economics -- i.e., what is discussed in the excerpt below.

NYTimes: Among the most astonishing statements to be made by any policymaker in recent years was Alan Greenspan’s admission this autumn that the regime of deregulation he oversaw as chairman of the Federal Reserve was based on a “flaw”: he had overestimated the ability of a free market to self-correct and had missed the self-destructive power of deregulated mortgage lending. The “whole intellectual edifice,” he said, “collapsed in the summer of last year.”

[Greenspan quote here.]

What was this “intellectual edifice”? As so often with policymakers, you need to tease out their beliefs from their policies. Greenspan must have believed something like the “efficient-market hypothesis,” which holds that financial markets always price assets correctly.

...By contrast, Keynes created an economics whose starting point was that not all future events could be reduced to measurable risk. There was a residue of genuine uncertainty, and this made disaster an ever-present possibility, not a once-in-a-lifetime “shock.” Investment was more an act of faith than a scientific calculation of probabilities. And in this fact lay the possibility of huge systemic mistakes.

The basic question Keynes asked was: How do rational people behave under conditions of uncertainty? The answer he gave was profound and extends far beyond economics. People fall back on “conventions,” which give them the assurance that they are doing the right thing. The chief of these are the assumptions that the future will be like the past (witness all the financial models that assumed housing prices wouldn’t fall) and that current prices correctly sum up “future prospects.” Above all, we run with the crowd. A master of aphorism, Keynes wrote that a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.” (Today, you might add a further convention — the belief that mathematics can conjure certainty out of uncertainty.)

But any view of the future based on what Keynes called “so flimsy a foundation” is liable to “sudden and violent changes” when the news changes. Investors do not process new information efficiently because they don’t know which information is relevant. Conventional behavior easily turns into herd behavior. Financial markets are punctuated by alternating currents of euphoria and panic.

Keynes’s prescriptions were guided by his conception of money, which plays a disturbing role in his economics. Most economists have seen money simply as a means of payment, an improvement on barter. Keynes emphasized its role as a “store of value.” Why, he asked, should anyone outside a lunatic asylum wish to “hold” money? The answer he gave was that “holding” money was a way of postponing transactions. The “desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. . . . The possession of actual money lulls our disquietude; and the premium we require to make us part with money is a measure of the degree of our disquietude.” The same reliance on “conventional” thinking that leads investors to spend profligately at certain times leads them to be highly cautious at others. Even a relatively weak dollar may, at moments of high uncertainty, seem more “secure” than any other asset, as we are currently seeing.

It is this flight into cash that makes interest-rate policy such an uncertain agent of recovery. If the managers of banks and companies hold pessimistic views about the future, they will raise the price they charge for “giving up liquidity,” even though the central bank might be flooding the economy with cash. That is why Keynes did not think that cutting the central bank’s interest rate would necessarily — and certainly not quickly — lower the interest rates charged on different types of loans. This was his main argument for the use of government stimulus to fight a depression. There was only one sure way to get an increase in spending in the face of an extreme private-sector reluctance to spend, and that was for the government to spend the money itself. Spend on pyramids, spend on hospitals, but spend it must.

This, in a nutshell, was Keynes’s economics. His purpose, as he saw it, was not to destroy capitalism but to save it from itself. He thought that the work of rescue had to start with economic theory itself. Now that Greenspan’s intellectual edifice has collapsed, the moment has come to build a new structure on the foundations that Keynes laid.

Keynes and Planck

Found in the comments on Economist's View:

Professor Planck, of Berlin, the famous originator of the Quantum Theory, once remarked to me that in early life he had thought of studying economics, but had found it too difficult! Professor Planck could easily master the whole corpus of mathematical economics in a few days. He did not mean that! But the amalgam of logic and intuition and the wide knowledge of facts, most of which are not precise, which is required for economic interpretation in its highest form is, quite truly, overwhelmingly difficult for those whose gift mainly consists in the power to imagine and pursue to their furthest points the implications and prior conditions of comparatively simple facts which are known with a high degree of precision.(Keynes, Essays in Biography 1951 158n)

It's true: powerful mathematical minds are not necessarily comfortable with the messiness of the real world. This observation might be applied as well to string (or more formal or mathematical) theorists vs theorists who are more data- or intuition-driven (often called phenomenologists, in a terrible use of terminology). Of course, some people (like Feynman, although he wasn't very mathematical by today's standards) are good at everything...

"We know a lot more than we can prove" -- Feynman