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Tuesday 4 April 2017

Trouble with Bubbles

Timo Henckel Research Associate, Centre for Applied Macroeconomic Analysis, Australian National University

Yes, Autumn is upon us again and the ides of march only passed a few weeks ago, so what a good time for the battle of the b-word to go bounding around the balustrades of the political discourse once again? This article is an eloquent explanation of asset bubbles in general, why this discourse never goes away and the characteristic of macroeconomics which draws me to it, sewn together with a succinct summary of cutting edge psychological macroeconomics. Anyone who is trying to comprehend economics to a level sufficient to understand the news should read this.

Essentially, the discourse never goes away because this field of study, probably more so than any other, is divided into political schools which are for ever in conflict with each other. So we have the 'Saltwater' school centred around the Ivy League Universities of the New England region in the USA, championed by Nobel laureate Paul Krugman, of 'The Conscience of a Liberal' fame; the 'Freshwater' school centred around Chicago, championed by Joseph Stiglitz with the US Federal Reserve as its mouthpiece; the 'Austrian' school, centred on the EU, championed by Angela Merkel; and last but not least, at the cutting edge of  understanding, the school which has no name at this stage, but has a strong Australian contribution, which I shall now dub the 'Keensian' school after its Australian contributor, my friend Steve Keen centred in England. There are probably other schools in this turbulent field which I have missed but I think these are the main ones.

The Saltwater school is neo-Keynsian, fairly closely following the tenets espoused by John Maynard Keynes in the 1930's in response to The Great Depression, and put into practice by FDR in the New Deal of those years. It practices a legally regulated market, laissez-faire government in the good times but intervention in the market to correct market failure when necessary, redistribution of wealth through taxation leading to an optimisation of social justice. As presently practiced in the Nordic Countries, its political expression is Democratic Socialism.

Favourite of the right-wing of the political spectrum, the Freshwater school is neo-classical in that it promotes economic paradigms which predate the Keynsian revolution and in fact go back to the 19th century. It promotes the idea of an unregulated market and minimal government intervention in the market. Since its inception the USA has conducted a huge experiment in socio-economic engineering by applying these principles to its society, until the shock of the Great Depression forced Keynsian ideas to the fore and the New Deal was born. When the New Deal principles stopped working in the 1970's (remember stagflation headlines) freshwater economists such as Milton Friedman hijacked macroeconomic practicum ushering in the great socio-economic experiment of the past 30-odd years beginning with Reaganomics and Thatcherism. Politically, this school expresses the neo-liberal and neo-conservative ideologies.

Another love-child of the right, the Austrian school, draws heavily on the work of  Friedrich von Hayek and his seminal work "The Road to Serfdom" (1944, University of Chicago Press). It is characterised by austerity policies and insists on budget and trade surpluses and is practiced in parts of Europe. Hayek wrote this in reaction to the work of  Keynes and it has been adopted by the right of the political spectrum as its guiding light.

Finally we have the Keensian school. A critique of the classical paradigm of economics has been ongoing since the publication of "The Wealth of Nations" by Adam Smith in 1776, which forms part of the bedrock of modern macroeconomics to this day. Many of the assumptions on which modern economics is based are vastly over-simplified. In the theoretical 'market' all practitioners are assumed to be perfectly rational 'utility optimisers', meaning everybody in the market acts in a rational way to increase their wealth. The Keensian school recognises this assumption as utter nonsense because all practitioners are human beings who do not always act rationally, and employs modern psychology to attempt to better predict market behaviour, so that governments can proactively intervene in markets to smooth the massive gyrations characteristic of these things.

Henckel summarises this new field thus:

"This misconception is the consequence of human behaviour and traits that depart from the fully rational paradigm so often assumed in formal economics. Instead, as behavioural economists argue, people exhibit a number of biases.
These include, for example, the desire to find information that agrees with their existing beliefs (called confirmation bias) or the tendency to form decisions based on the most readily available information (called availability bias). People experience and seek to resolve their discomfort when they have two or more contradictory beliefs, ideas, or values and they also employ simple abstractions in thinking about complex problems and events (framing).
People are poor intuitive statisticians and care more about avoiding losses than about experiencing gains (called loss aversion). The list of flaws in human behaviour goes on. Moreover, humans, social animals that we are, compete with and emulate our peers, herd like sheep and act on rumours."

Asset bubbles are a market failure. It is a function of government to correct market failures in such a way as to minimise social pain caused by them. It would make a lot of sense if economists, the supposed experts in such things, told us how to go about this. Instead here we have full admission from one of its highest academic practitioners that there is no agreed definition of  'asset bubble', and if you can't define it, you can't say for certain that one exists; and if one doesn't exist, then why would you do anything about it? This sounds a lot like a justification for laissez-faire government. It plays strait into the hands of right-wing parties.

"Economists disagree on how to define a bubble, or even whether bubbles exist. Intuitively, a bubble (and this applies to any asset, not just real estate) exists when the price of an asset is over-inflated relative to some benchmark. And here’s the rub: no one can agree on what that benchmark should be." 

As mentioned above, the modern academic field of economics started with the publication of  "The Wealth of Nations" (Smith, Adam, 1776). With close to a century's head start, the modern academic field of physical science began with the publication of "Mathematical Principles of Natural Philosophy" (Newton, Sir Isaac, 1728{English}, 1687{New Latin}). Thus began a rivalry and jealousy that has lasted nearly 250 years. Economist looked on physical scientists, with their higher social standing; their absolute physical laws; their precise mathematical tools; their evidence-based scientific method, and were overcome with envy, so they endeavoured to mimic them.

You see economics had always been classed as a 'social' science, not a 'real' science at all, and economists wanted to be seen as real scientists, so economic theoreticians, from the start, adopted the bits of physical science they thought would make them look more like real scientists. Physics uses precise mathematical tools they saw:  "if we use precise mathematical tools too everyone will think we are real scientists", they thought to themselves. You can hopefully perceive desperation holding back my innate urge to unleash caustic wit in waves of ridicule upon this entire pretentious practice.

So this is why I find this topic so interesting.

My primary training is in physical science. I became aware of economics quite late, but have studied both of these fields to a high level. At masters level the economics being taught was laughable from a scientific perspective. I have to think this is the highest level of economics available. All of the bits of scientific methodology which make it work are tossed into the dustbin by economists. For nearly 250 years they have focused on the one aspect of physics they think will deliver them the status of true science: precise mathematical tools delivering absolute economic laws. This article shows that they can't even get the basics right. When a scientist says 'precise' that person means all the words, variables and concepts used have exact, black-and-white definitions, agreed and understood by all scientists. Asset bubbles have no definition of this sort, so any attempt to use precise mathematical tools to describe or analyse them is doomed.

This is not the only example: in fact economics is riddled with ambiguous concepts and abused methodology, but I shall leave it to my illustrious readers to find more.

In its quest to become a real science economics continues to evolve. It straddles the nexus between precise, austere, rational, logical, austere reality and messy, ambiguous, irrational, emotional, human reality. One day the twain may be met.    
























    

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