Sunday, May 27, 2012

A mathematician looks at economics and is baffled by what he sees.

A foundational principle of modern economics is that the creation of credit leads to economic growth. That precept underlies need for quantitative easing, and it is central to the question of what role monetary policy can and should play in stimulating a faster recovery from the Great Recession. It is also the subject of a debate between one of the world’s most prominent economic scholars, Paul Krugman, and a feisty Australian economist, Steve Keen.
Krugman is an unusually public figure for an academic. The Nobel Prize-winner and Princeton professor is also a widely-read New York Times columnist and prolific blogger, with the gift – unusual for someone in so wonky a profession – of clear and persuasive prose. He has earned a large and passionate audience, among them both ardent acolytes and rabid detractors. Krugman represents the mainstream of neoclassical economics, which believes that a combination of central bank monetary policy and government fiscal policy can moderate the business cycle.
 
Among the dissidents is Keen, the author of a provocative book, Debunking Economics. By his own admission, Keen is proudly out of the mainstream, but also able (“because of impediments like academic tenure,” he says in his book) to challenge it without fatal retribution. Keen thinks central bank controls are not as effective as Krugman believes, because private banks can create money in the form of debt through a process that is beyond the central bank’s control. Because of that, the economy will regularly experience “financial instability,” as advocated by Keynes’s disciple Hyman Minsky.
 The debate in the blogosphere between those in the Krugman camp and those in the Keen camp has generated more heat than light; but the core of the debate is whether or not private banks can create money “out of thin air” to their heart’s content, by extending credit – leaving the central bank with no choice but to sanction this money creation.
Read it at Advisor Persectives
An Attack on Paul Krugman
By Michael Edesess
May 15, 2012
(h/t paul in the comments)
...there are really two aspects to the debate. The first is the general charge that all of neoclassical economic theory is bankrupt because it is enthralled with equilibrium, and therefore it cannot model or understand the dynamic evolutionary economic process. That is to say, the essential nature of the economy is to be indisequilibrium, so theories obsessed with equilibrium cannot model it. 
This charge seems wholly valid to me. In answer to the mainstream’s deficiencies, Keen said in my interview with him, “I want to eliminate the neoclassical mainstream and replace it with a Schumpeterian dynamic growth evolutionary mainstream.”Schumpeter, you’ll recall, was the economist who coined the term “creative destruction” to characterize the capitalist economic process – a term beloved by nearly all economists, but of which it is difficult to find any trace in mainstream economic models. Says Keen, “Creative destruction doesn’t involve equilibrium, so they leave it out completely. It’s about how investment comes in pulses and waves … so you get an inherent explanation for the cyclicality of capitalism out of Schumpeter.” 
The second aspect is a chicken-and-egg problem: Do banks take in deposits and then lend, or do they loan first, then use the proceeds of the loan to create deposits? It is not merely a chicken-and-egg question – those, like Keen, who say banks can create money out of thin air also say that the central bank must condone, willy-nilly, this so-called “endogenous” money creation. Krugman, on the other hand, says the central bank can control the process. That is, he believes money is created only “exogenously” by the central bank. Keen is a disciple of Hyman Minsky, who was a disciple of John Maynard Keynes but also of Schumpeter. Minsky believed that this process of banks creating money, in the form of debt, would inevitably lead to frequent financial bubbles and crises. 
Judging from how much feverish blogging there has been surrounding the Keen-Krugman battle alone, this is a thorny question to resolve one way or the other. The amazing thing is that, in this debate, one side or the other will present what appears to be a very simple proof that they are right – and yet the other side is not persuaded in the least.
*******
I am particularly baffled by these debates, because my background is in pure mathematics. Economics pretends to be mathematics, but it is not mathematics. There is a major difference. No mathematician uses a term in a formula, or a statement of a theorem, unless that term has first been defined with excruciating precision. Hence, there is no question of what the term means, let alone any debate that is carried on only because two disputants have different concepts of the meaning of their terms. As a result, a very simple proof of something will invariably persuade the other side. The cost of this, however, is that mathematics is strictly limited in what it can define and prove. 
In economics, it is completely different. Terms are used in formulas without ever having been precisely defined. Economists may think they’ve defined them, but they should try reading some real mathematics to see what a precise definition truly is. The economists, I think, leave the work of definition to be inferred from the way the terms are used in the formulas. This, to me, is weird – but I suppose it could work, and it does work sometimes, but more often it leads to ridiculous debates that leave matters of real importance unexamined.
That seems to be the case in the Keen-Krugman faceoff. The most central terms – inflation and GDP – are so riddled with measurement problems that they are almost arbitrary fictions, a reality with which no one ever grapples. There is never so much as a nod to the fact that a large body of intelligent people believe that economic growth, by mathematical necessity, cannot continue forever, or even for long – yet efforts to define clearly enough what “economic growth” means in order to close the gap with this external (and sometimes internal) body of thought are rarely seen in debates among economists.
******
The source of all the confusion, in my view, is the idea that if you can’t measure something and model it mathematically, it has no meaning. There is too much mathematics used and expected in economics, and too much of it is of poor quality and distorts the ideas it is meant to undergird. Keen agrees. “If you’re actually aware of the limitations of mathematics, you say, ‘Well, this is a guide, but I could have missed something,’” he told me. “So there’s more modesty in a proper non-equilibrium dynamic modeling approach than you’ll ever get out of neoclassical equilibrium modeling.”

35 comments:

Matt Franko said...

"This, to me, is weird "

I'll say!!!!

Matt Franko said...

"The most central terms – inflation and GDP – are so riddled with measurement problems that they are almost arbitrary fictions, a reality with which no one ever grapples. "

If we instead looked at unemployment as measured by folks who report to the JG as the "central term", that would NOT be riddled with measurement problems... hang so-called "inflation", that is a garbage term.

Matt Franko said...

Interesting phraseology by Keen here:

“If you’re actually aware of the limitations of mathematics,"

Mathematics is "limited".... I dont think it should be described that way... it's like saying truth is "limited"????? doesnt seem like this adjective should be applied to math....

I dont think one should look at math as "limited"... it is a form of understanding, etc...

I would agree that "math" should not dictate policy.

Interesting choice of words...

Resp,

Matt Franko said...

"A foundational principle of modern economics is that the creation of credit leads to economic growth. That precept underlies need for quantitative easing"

No credit is created by QE.

This guy doesnt understand the system either....

Leverage said...

Actually is not mathematics which is limited, as an abstract conceptual framework to communicate information, but is the information the problem (which is also a mathematical problem anyway, in a secondary way).

Mathematics has limitations when representing real world relations which are complex because of information issues. It's materially impossible to recreate world relationships in a 1:1 way because you would actually need an other universe with the same amount of matter this ones has to do so.

Keynes was very good about uncertainty and one of the few economists (although he was more a mathematician actually!) who really got it, uncertainty is a by-product of these limitations. Uncertainty is basically a lack of information AND a lack of computation power to process it all (both of these process are unsolvable in our current universe and will always be; that's why animal 'computers' have evolved some complex decision mechanism based on heuristics and environment feedback loops, by trial & error, rather than being pure logical machines).

Matt, mathematics is a closed (abstract) system defined by axioms, but it's impossible to be proven internally both as true and complete system at the same time, can't have it all (see Gödel incompleteness theorems).

P.S: Even most quants working in finance don't know how the system really works, don't expect mathematicians or scientists to know better. There is a serious practical misunderstanding about how the monetary system and banking works, something that should be taught in high school to everybody.

paul said...
This comment has been removed by the author.
Tom Hickey said...

Matt, following up on Leverage, I think that what SK is saying is that mathematical models are limited. This is his point about economics abandoning static models for dynamic models.

Then there is using the wrong type of model for the data. Equilibrium models presume ergodicity, whereas uncertainty rules in the real world. As David Hume pointed out centuries ago, that the future will be like the past is a belief (assumption) rather than a fact. That assumption works reasonably well in the hard science which deal with changes and exchanges in mass/energy/space/time but not so well in the social sciences, of which economics is one, which is why it used to be called political economy until the advent of New Classicalism. But Alfred Marshall, to his enduring credit, warned about the limitations of math models back then. He was not heeded subsequently.

paul said...

Matt,

This guy gets it right when he points out that economics attempts to use "bad math" to prove itself and should be called out on it.

He then makes the leap that just because something can't be described as a mathematical model doesn't make it wrong.

He skips over the option of using "good math".

I think he is confusing "bad math" with the inability to apply math properly. A lack of understanding of the underlying system.

I/we? believe that MMT has found not only the "good math", but the perfect math, the right math, applied to the right system in the right manner.

As someone once said, practice doesn't make perfect. Perfect practice makes perfect.

I keep looking for the math flaw in MMT. Haven't been able to find it yet.

paul said...

"…the creation of credit leads to economic growth…"

The converse of that is that the satisfaction of the liabilities created by credit leads to a contraction in economic growth.

Tom Hickey said...

Actually, Godley SFC models are accounting-based rather than math-based.

Accounting models make doing credible macro possible, whereas no sufficiently complex math models have yet been developed that meet the requirements.

paul said...

Accounting is based on math though.

Further, the economic system is based on simple math, a simple closed system.

It is behavioral patterns that aren't simple.

There are no behaviors that can make the math component go where it can't go, for example cause money creation from within the system.

Without money creation there cannot be nominal growth. Without nominal growth there cannot be net profit or saving for USA's balance sheet.

That would be a perpetual-motion machine.

The behavior effect on economics can and must be separated from the math part for proper analysis, otherwise the problem is too complex to deal with.

Behavior cannot overcome the math constraint.

Leverage said...

Well, one of the good things of MMT description of the system is that ( even if most MMT'ers wouldn't agree with that) you don't really need a growing economy to have an stable economy. That's basically the most biggest mathematical flaw in economics, the dependency on exponential functions for the system to keep working, and that's what basically happened in 2007/2008, an exponential function collapsed with reality (credit creation). Power laws and exponential functions work really bad in our natural environment world, and are usually kinda limited and/or usually self-collapsing phenomenons.

I think Japan has more or less exemplified that with a modern monetary system basically you can have zero growth without society collapsing. This would probably be impossible in a 'private money system' (one for example dominated by gold standard). An other question is how the income distribution and consumption is, how savings are distributed, etc. but it can reach stability.

That's why is one of the few things that is worth pursuing in economics nowadays. (And it's not only because resource constraints, it's because at some point humanity will reach a population plateau and keeping real growth exponential is simply going to be impossible, indeed, it already is impossible for well developed nations which are struggling to keep any sort of positive growth).

Tom Hickey said...

Without money creation there cannot be nominal growth. Without nominal growth there cannot be net profit or saving for USA's balance sheet. That would be a perpetual-motion machine.

Right, and that's largely in the accounting.

The behavior effect on economics can and must be separated from the math part for proper analysis, otherwise the problem is too complex to deal with.

Right.

Another factor that can becomes a constraint is real resources, especially energy, since by definition the real economy is a complex function of work in the scientific-engineering sense. Even though it is complex it is basic science.

Behavior cannot overcome the math constraint.

True, but behavior can take many forms and modeling that causally is the problem of social science. If economics stays away from trying to model the behavioral aspects and doesn't introduce them into the models otherwise, then it is a straightforward issue that can be dealt with. For example, the aggregates that make up the sectoral balances don't require understanding all the behaviors that lead to them, and the relationship among the various sectors invariably holds due to the accounting contrains of double-entry bookkeeping.

The problems arise from trying to include behavior. Given that social science is in its infancy, there is a lot that is not known and a lot which gets presumed. This involves assumptions and many of these assumptions are philosophical, that is, depend on a lot of appeals to aprioris that are taken as self-evident.

Moreover, many economists and most mainstream economists don't leven ook at research in the life and social sciences, so their assumptions are just uninformed. But many models, e.g., expectation-based models, are dependent on such assumptions involving causation, which is one of the most difficult aspects of science to get right.

Daniel Kahneman's Nobel has thankfully begun to change that with recognition of behavior economics, so that economists are starting to pay attention to how human beings actually function, rather than reassert some 18th century idea of human beings being chiefly "rational" and naturally individualistic (the basis of max u). A lot of work has been done in this area that is just not incorporated yet. When it is, neoliberalism is finished.

I was planning on putting up something on Kahneman anyway.

paul said...

@Leverage

Yeah, the system you are describing requires redistribution and thus a non-profit economy, at least in nominal terms.

That's how it looks to me anyway.

I'm all in favor of taxing the heck out of rents and disallowing wealth accumulation above some reasonable threshold.

Eventually we will have to have a steady-state economic system, whether we like it or not, unless we can solve the space-travel problem very quickly.

Tom Hickey said...

Up until now, most "profit" has come from privatizing the commons when all is said and done. With a dwindling commons that era is coming to a close.

But innovation is capable of doing more with less, so that a no-growth stable state society can improve its living standard potentially almost without limit in the sense that knowledge, being metaphysical, is not subject to physical limits. This was the key point of Bucky Fuller's work over fifty years ago.

Up until now, most "profit" has come from privatizing the commons when all is said and done. With a dwindling commons that era is coming to a close.

paul said...

@Tom

Yes and I'm not claiming that behavior isn't important.

Bad behavior can push the sectoral balances in directions that would be bad for most everyone.

I'm just trying to make the point that the effects of different behavioral patterns on the economy are predictable.

It's behavior itself that can be unpredictable. Further, we seem to ignore what we do know about behavior in trying to solve our problems.

Tom Hickey said...

"Eventually we will have to have a steady-state economic system, whether we like it or not, unless we can solve the space-travel problem very quickly."

Right, now the push is on to privative various regions of space, which entrepreneurs see as a limitless physical resources. The latest NASA-sponsored space project was largely privately financed and engineered.

Leverage said...

I wish I was wrong but expecting growth (growth in resource extraction anyway) by colonizing space right now is kinda stupid. We should be working on recycling our current bast amount of resource utilization, diminishing waste and more efficient consumption. plus working on how to extract the insane amount of energy the Sun donates freely each day to us, we don't need to go to the outer space for resources, we need to get better at using what we have that is more than enough (the Sun in one day irradiates the Earth with more energy than humanity has ever used). We need an stupid amount of money to finance ivnestments and research in that direction and not thinking we have run out of money or our grandsons will be paying our "debts" (the most stupid phrase ever).

Putting a kg of mass in the space costs billions more than any economic profit it's going to generate nowadays. Even if space programs skyrocket (heh) it will take at least one or two centuries until we can start a serious colonization of the solar system (which will be very limited early in any case, to resource extraction probably, mining asteroids and such things for example).

In any case, hardly going to solve our current economic problems, this is similar to new jobs created by Internet. Companies like Facebook are very limited in job creation, and automatization is not going to be stopped. By half this century is most probable that 85% of the worldwide economy is composed of services, is getting silly at this point, by the end of this century (unfortunately most probably no one of us ill live so long, unless major breakthroughs happen in bioengineering, which is possible anyway) a 5% of the population will be able to produce more goods than all the population needs. The 'economic problem' as defined by Keynes has already been solved, as we waste 50% of the food we produce, is just a matter of distribution and efficacy.

The problems will have to be tackled other way. Look what nations like Japan and Germany have to do... they already have relatively strong social cohesion and programs compared to nations like USA, and they still need to use merchantilist policies to import jobs, imagine when this trend is global and we are in a race to the bottom of job scarcity due to productivity gains.

I'm amazed how much we have progressed in a few decades, and I was not long ago so wrong about this to be honest, almost bought the social-darwinist agenda. Reality is that human population has grown a lot in half a century and still we had decreasing inflation trend and a lot of wealth being created with the overall population getting richer, just if it hadn't gone most of it to the top 1% we would be swimming in wealth (plus they are the biggest inflation creators anyway, directly, by consumption, or indirectly, thought corporate welfare and government subsidies, like treasury notes).

paul said...

I should have included a roll-eyes when I suggested space exploration/colonization as a possible solution.

That one ranks right up there with playing the lottery to provide for our retirement.

Tom Hickey said...

Hey, Stephen Hawking said some time ago that humanity will be toast without preparing for it ASAP and I would say that he understands likely something about systems.

Matt Franko said...

Great thread.

I agree with comments wrt math and "limitations".

That said, I still dont understand what Keen is trying to accomplish even if he is pursuing "dynamic" models.

It would seem to me that even if he is acknowledging that we dont have a system that can function correctly as a "closed system" (ie without injection of NFA), he has to still rely on ex-post data in his models. (driving in the rear view mirror, or "Technical Analysis in stock market trading).

I have a hard time seeing any future benefit from his work in this regard.

Unless he is just trying to show sort of "mathematically" that current "static" models dont work which will cause policy makers to change course.

I can already see that without Keen doing anything...

Resp,

Matt Franko said...

Paul,

"satisfaction of the liabilities created by credit leads to a contraction in economic growth."

This is good.

Taxes apply as a "satisfaction of liabilities" as well.

Think of govt spending as "creation of credit" ie in this case a "tax credit". Then we (non-govt) have tax liabilities, which we have to "satisfy", when we satisfy them (pay taxes) this is a "contraction in growth" ie fiscal drag.

I've never read what you have written here put this way.

"The satisfaction of the liabilities created by credit leads to a contraction in economic growth."

What about bank loans as "liabilites created by credit"?

Seems like satisfaction of the principle portion of the loan is a wash perhaps not a "contraction"?

I guess what I saying is that I see the applicability of your statement here for the govt/non-govt "credit" relationship, but dont see it straightaway for the borrower/lender credit relationship...

Resp,

Matt Franko said...

Lev,

Good points about "uncertainty".

Bill Mitchell has described the possession of "money" (savings I guess) as "a hedge against uncertainty" which I thought was good.

http://mikenormaneconomics.blogspot.com/2012/02/mitchell-hedge-against-uncertainty.html

In this regard "uncertainty" is screwing everything up as it causes people to desire to save.

There is too much 'uncertainty'.

We should be working to eliminate it.

Resp,

paul said...

Matt,

Seems like satisfaction of the principle portion of the loan is a wash perhaps not a "contraction"?

I look at it this way…

When the credit is issued, the money is spent. I assume here that most people don't borrow money to put it into savings. The spending creates economic expansion.

This is in mathematical terms "spending future income".

When loan payments are made, this is current income earned taken out of the spending cycle. It's a reversal of the expansion albeit at a slower rate (the spending occurred lump-sum, probably in one transaction).

The contraction is delayed by the continuous expansion of credit - it masks the coming contraction.

When the expansion of credit reaches the limit of borrowers ability to service the debt is when the contraction occurs, and suddenly.

We just watched it happen. The middle class lost $Trillions in wealth and are saddled with untenable debt.

That's why I say satisfaction of the liabilities is a contraction in economic activity.

The interest is another story. It requires access to funds that weren't created with the loan so it depends on net government spending into the right hands.

Obviously lowering taxes on the rich isn't going to solve this problem.

Leverage said...

Tom, paul, I should clarify I'm not against space programs investment and I agree completely with Hawkings.

It's demonstrated that space programs are probably amongst the most productive things humanity has ever done. Most of our current technological benefits wouldn't exist without these programs, our modern societies are unthinkable without space programs, period. An excellent example of how governments can indeed create wealth directly and indirectly (through partnerships with the private sector) despite 'Austrian' propaganda.

I cry every time I see cuts in science budgets or space programs, it's a total disaster and failure of the system to me.

But that said, these are not going to solve in the short/middle term the problems of millions of people.


Matt,

On keen, his models have value IMO, they show how 'endogenously' the system fail, it may be clear to you, but it's not clear to a lot of morons or the economic profession. It's applicable policy wise, when regulating the banking system, too.

And a logical conclusion is that governments must plug the holes. In fact, if you read Keen suggestions last times, they are not that different from MMT line of though, basically he is advocating for QE for the public instead for bankers (a bail out of the population from debt), basically means increasing NFA and distributing them amongst society.

I certainly prefer to support this than to support Krugman pushing people into debt again (even if part of his policies are to increase public deficit), feeding the spending 'consumption growth machine' through credit.

paul said...

I'm of the opinion that use of credit for consumption is a fools errand.

We reduce our spending power so we can "have it now" while spending money we haven't earned yet.

I can see the usefulness of credit for business expansion, but the consumer/working person bears all of the cost of the financing since it is passed on.

We pay for everything, so money should be created into our hands.

@Lev

I'm pro-space-science-technology too but I don't think it's going to bail us out of this mess. Not going to happen quick enough.

I would much rather spend money on that than blowing stuff up overseas.

Matt Franko said...

Lev,

I see that yes... I would point out that speaking for myself and perhaps Paul, I am not trying to point out that many dont "get the math" in order to make the claim that "we can solve this with math".

I point out the math to show how the current policy approach doesnt work, folks who dont "get the math" cant see the futility of all of this...

To your point perhaps this is what Keen is doing too.... without directly "calling moron" on them... I guess Keen is relying on the Academe of Math to get involved and expose the mathematical failure of the Academe of Economics...

Resp,

Matt Franko said...

Paul,

"When loan payments are made, this is current income earned taken out of the spending cycle. It's a reversal of the expansion albeit at a slower rate (the spending occurred lump-sum, probably in one transaction)."

Got it.

Resp,

PS

"Paul's Law": "The satisfaction of the liabilities created by credit leads to a contraction in economic growth."

;)

Tom Hickey said...

"I'm of the opinion that use of credit for consumption is a fools errand."

It was the practice until recently. Before the neoliberal era in which wage suppression was offset by private debt for consumption, prudent lenders only extended credit for investment (residential RE is considered investment in accounting practice and some durable goods. Some stores did extend credit for purchases, but this was expected to be paid down on a monthly basis. Charge cards like American Express and Diner's Club where mostly used to business expenses and they were paid down monthly, too.

Then the era of credit cards dawned and with it the era of looser and looser credit to fuel consumption, while wages remained stagnant and the real wage fell. It took about thirty years for that to implode, and it was quite a ride. That may be over now, it seems.

Tom Hickey said...

Another issue. Use of credit is increases the actual price of assets and goods due to the interest payments. It's possible to pay more in interest than the item cost in the first place.

paul said...

"it's possible to pay more in interest than the item cost in the first place."

A home mortgage for example, esp. a 30-year.

Ramanan said...

Tom,

"Actually, Godley SFC models are accounting-based rather than math-based.

Accounting models make doing credible macro possible, whereas no sufficiently complex math models have yet been developed that meet the requirements"

Yes they are accounting models, but the models use the mathematics of difference equations/recurrence relations and sequences.

Tom Hickey said...

Thanks for the clarification, Ramanan.

What I was specifically thinking of is that "math-based" model such as are used ordinarily in economics are built on assumptions, so that while the math is correct, the model doesn't necessarily represent reality. Conversely, Godley models begin with accounting instead, which connects to the real economy through quantification of transactions. e.g., nominal price quantifying real value of goods and assets, as recorded in the accounting data. so the model begins much closer to facts and stays close to them, i.e., aggregates can in principle be deconstructed by examining ledgers. On the other hand, it is the assumptions of the mathematical models used in economics that are the bones of contention.

Perhaps you could comment on this.

Ramanan said...

Tom,

Yeah standard models neither get the behaviour/causality right nor the accounting. SFC models on the other hand starts with taking care that the accounting is right and use Post Keynesian causalities to analyze economies.

Roger Erickson said...

Classic "economics" is a court phenomenon. It allowed arbitrary power centers leeway to commission studies of how to prolong their hegemony.

Once endowed, the institutional momentum of such propaganda forms require that the trappings of any & all non-aligned sciences be utilized for continued self justification.

If math weren't misused by Orthodox eCons, they wouldn't be able to justify awarding themselves Nobel Prizes.