Saturday, May 22, 2010

The Non-Existent Hand...

My letter on the Stiglitz review of Robert Skidelsky's "Keynes: The Return of The Master" is printed in the May 27, 2010 issue of the London Review of Books. Paul Davidson

It reads as follows:(Sent to me by Paul Davidson__The economist we need to solve the present world crisis...)


The Non-Existent Hand...

Joseph Stiglitz criticises Robert Skidelsky, Keynes’s biographer, for not understanding Keynes’s theory, but in doing so reveals his own imperfect understanding (LRB, 22 April). The basis of his complaint is Skidelsky’s distinction between risk and uncertainty. Risk, Skidelsky explains, exists when the future can be predicted on the basis of currently existing information (e.g. probability distributions calculated from existing market data); uncertainty exists when no reliable information exists today about the future outcomes of current decisions, because the economic future can be created by decisions taken today. According to Stiglitz, this is a distinction without a difference, and ‘little insight’ into the causes of the Great Recession is gained from Skidelsky’s emphasis on uncertainty as opposed to risk.

But this is not what Keynes believed. The classical economics of Keynes’s time presumed that today’s economic decision-makers have reliable information regarding all future outcomes. I have labelled this the ‘ergodic axiom’. By contrast, Keynes argued that ‘unfortunate collisions’ occurred because the economic future was very uncertain. ‘By very uncertain,’ he wrote, ‘I do not mean the same thing as “very improbable”.’ No reliable information existed today for providing a reliable forecast of future outcomes.

This is the very proposition that Stiglitz denies. All that is needed to provide better insight into the workings of the market, he thinks, is ‘small and obviously reasonable change in assumptions’; for example, that reliable information about the future does exist but that different individuals have access to different information. The only necessary policy is ‘transparency’: to make complete information about the future available to all. The classical ergodic axiom is correct, provided one accepts that not everyone has access to all the information that exists.

For Keynes the inability of firms and households to ‘know’ the economic future is essential to understanding why financial crashes occur in an economy that uses money and money contracts to organise transactions. Firms and households use money contracts to gain some control over their cash inflows and outflows as they venture into the uncertain future. Liquidity in such an economy implies the ability to meet all money contractual obligations when they fall due. The role of financial markets is to assure holders of financial assets that are traded on orderly markets that they can readily convert these liquid assets into cash whenever additional funds are needed to meet a contractual cash outflow commitment. In Keynes’s analysis, the sudden drying up of liquidity in financial markets, occasioned by sudden drops of confidence, explains why ‘unfortunate collisions’ occur – and have occurred more than a hundred times in the last 30 years, according to Stiglitz.

By contrast, Stiglitz implicitly accepts the orthodox view that all contracts are made in real terms, as if the economy were a barter economy. Consequently people’s need for liquidity is irrelevant. Stiglitz indicates that he and Bruce Greenwald have explained that financial markets fail ‘because contracts are not appropriately indexed’, i.e., contracts in our economy are denominated in money terms rather than ‘real’ terms. He suggests that if only such contracts were made in real, rather than monetary, terms we would not suffer the ‘unfortunate collisions’ of economic crisis. If only we lived in a classical world, where contracts would be denominated in real terms! But in a money-using economy, this is impossible.

Paul Davidson
Journal of Post Keynesian Economics, New York

Friday, May 14, 2010

About the Euro Crisis: The Experts Are Wrong, the German People Are Right...

About the Euro Crisis: The Experts Are Wrong, the German People Are Right...
Fabius Maximu

The great and wise tell us that the European unification project — of which the Euro is now center state — is good. And the foolish German people are short-sighted and foolish to oppose aid to Greece that’s necessary to preserve it. They’re wrong. The German people are right.


From Eurointelligence’s coverage of the crisis:

•“The main criticism of Merkel is … that she allowed a xenophobic climate to build up in her own party.”

•“The more worrying development is the resurgence of German nationalism and euroscepticism, a trend Merkel tried to exploit for her own political benefit.”

•“Greek aid is unbelievably unpopular, with 86% opposed according to a poll published last Sunday. Come to think of it, there are not many issues in a democracy on which 86% of the people agree on.”

J├╝rgen Habermas (sociologist and philosopher) said (source):

"Such a lack of solidarity would certainly scupper the whole project. Of course, Merkel’s statement was intended at the time for domestic consumption in the run-up to the important regional election in North Rhine-Westphalia. But there can be no better illustration of the new indifference of the new Federal Republic than her insensitivity to the disastrous impact of her words in the other member states. Merkel is a good example of the phenomenon that “gut politicians who were ready to take domestic political risks for Europe are a dying breed”.

In fact the system is rotten to the core and doomed to fail. A common currency without a strong nation cannot function, for reasons well-understood at the beginning (see this post from July 2008). Europe’s leaders gambled that they could build this structure from the top down. But Europe remain separate nations where it counts, in their people’s minds and hearts.

What does this tell us about the crisis?

•This means the Europe’s economies remain distinct units. God Himself could not set an interest rate and level of the Euro that would work for both Germany and Greece. Here lies the cause of crisis.

•This means the central government, the EU and European Central Bank, remain foreigners. They lack legitimacy, and as such cannot impose harsh measures. Here lies the current problem, the rock on which the current prescriptions will fail.

•The massive EU and IMF loans will merely allow private investors to roll out of their bonds as they mature, with the debt moving onto the EU and IMF balance sheets — to suffer the eventual default (in some form). This bailout means that private investors again avoid the consequences of their foolish decisions, as SOP in our new system of State Capitalism.

•If the Greeks were cut loose from the Euro, their government could take the necessary harsh steps, buffered by the tools that have worked for others (in various combinations): IMF aid, fiscal austerity, currency devaluation, and monetary expansion.

Germany’s people know this, and rightly oppose bailout plans primarily designed to protect banks and other institutional investors. They want capitalism and free markets. Which means allowing the Greek people to re-build their financial system on firm ground — and giving them (not banks) aid to mitigate the shock. They’ll decide how to do so, and gain the resulting rewards (or pain). They cannot do this in the European Economic and Monetary Union.

The Greek crisis is just another chapter in the ongoing transition from the dying post-WWII economic regime. While the process will take years to complete, the sooner we open our eyes the sooner we can look for the facts and wisdom with which to build a new system.

Sunday, May 09, 2010

Sooner Rather Than Later...

Sooner Rather Than Later By Philip I. Levy

Why would the U.S. stock market drop so dramatically this week, just after Europe and the IMF agree to back Greece and the Greeks adopt a painful package of fiscal measures? Even if Thursday's roller-coaster ride turns out to be partly due to the mother of all typos that cannot explain the week's global stock market slide. One possibility is that long-term economic arguments are telescoping into the short-term.

One of the great memes to emerge from the financial crisis was that economists had no idea what they were talking about. After all, professional economists had urged deregulation and faith in markets; an internet full of amateur economists could easily see that such misguided nuggets of advice were solely responsible for all the woe that ensued.

This analysis was always a bit problematic. First, we may need a bit more perspective to properly attribute causality in the crisis. The snap analyses have been politically convenient, in that they have supported snap policy responses, but they have their flaws. For example, what about Fannie Mae and Freddie Mac? These were hardly paragons of unfettered market extremism and they were central to the housing bubble and to the cost of the eventual government bailout. I know firsthand that this was a crisis foretold by economists, since I served as a senior staff economist for Greg Mankiw when he chaired President Bush's Council of Economic Advisers. Greg, working with excellent economists like Karen Dynan, now of Brookings, was vocal about the dangers posed by these government-sponsored enterprises and helped formulate proposals for reining them in. Congress blocked the proposals.

Economics is best at describing incentives for behavior. As a forecasting tool, economists assume that sooner or later people will respond to those incentives. This works reasonably well in the long run, but far less well in the short run, when psychology dominates.Setting aside the pathology of the financial crisis, there is a second problem with the refutation of economics that is more fundamental. Economics is best at describing incentives for behavior. As a forecasting tool, economists assume that sooner or later people will respond to those incentives. This works reasonably well in the long run, but far less well in the short run, when psychology dominates. Economists are not so good at predicting next quarter's consumer behavior; they are much better at predicting the ultimate consequences of unsustainable debt.

And so we come back to today's shaken market. Financial economists have for decades espoused the "efficient market hypothesis," which roughly said that all the relevant information for stock prices would be built into today's quotes. If not, there would be an incentive for someone to act on the omitted information and make some money off it. Yet the persistence of housing bubbles and overvalued feeble institutions in the prelude to the crisis seemed to mock the very idea. Prices could be wrong for a long time, it seemed. But the incentives for acting quickly were still lurking out there. Investors did not heed them in the past, and they got burned for waiting. What about the next time?

Now turn to Europe. Its crisis was supposed to play out in an orderly and gradual fashion: Greece would look ready to crumble, but it would be small enough to risk a bailout. There was not much hope that the healthy European economic powers could bail out every troubled country on Europe's perimeter, but by taking care of Greece today, they could buy themselves some time until the next country went. Maybe something good would happen in that interregnum (e.g. a surprise burst of growth, which cures many ills) or maybe today's politicians would leave office, in which case it would be somebody else's concern.

From an efficient markets perspective, there was a serious problem with a crisis unfolding in such an unhurried fashion. Looking ahead to the final stage, when a truly big country like Spain went and was too big to be bailed out, those left holding the debt of the fallen countries--or of the banks who had lent them money--would be hurting badly. Investors might always try to enjoy high yields on debt for a while, then sell before things really turned bad. But who knew when that would be? That strategy failed miserably for those entangled with Lehman Brothers. Perhaps it would be safer to exit now and not lend to anyone dubious.

CNBC reported today's stock market swoon thus:

The Dow plunged Thursday amid buzz in the market that European banks have halted lending.

One trader . . . said he heard fixed-income desks in Europe shut down early because there was no liquidity--basically European banks are halting lending right now.

"This is similar to what took place pre-Lehman Brothers," the trader said.

And thus longer-term incentives telescope into the short term. Beware the return of efficient markets.

Philip I. Levy is a resident scholar at AEI.