Monday, September 22, 2014


Sunday, September 21, 2014

In the long run we are all Baroque

Terence Hutchinson concluded his appendix on "Some postulates of economic liberalism" in Significance and Basic Postulates of Economic Theory with the admonition, "It is high time to put these theories [laissez faire and equilibrium doctrines] firmly back in their place as Utopian constructions." He cited S. Bauer's 1931 article, "Origine utopique et métaphorique de la théorie du “laissez faire” et de l’équilibre naturel."

Prominent in Bauer's discussion is the role of Baltasar Gracian's Oráculo Manual, which was translated into French by Amelot de la Houssaie in 1684, in popularizing both the notion and the term, laissez faire. Pierre le Pesant Boisguilbert is credited with introducing the term into political economic thought in a book published in 1707. It is conceivable that Keynes knew of the Gracian maxim because he used the image Gracian had used of tempestuous seas in his famous rejoinder about "the long run" being "a misleading guide to current affairs."

In his book Hutchinson noted that "several writers have argued that some such postulate as 'perfect expectations' is necessary for equilibrium theory." This observation lends a special note of irony to Gracian's coinage of laissez faire. In his discussion of Gracian's Oráculo, Jeremy Robbins highlighted the observation that:
Gracián’s prudence rests firmly on a belief that human nature is constant... In Gracián’s case, human nature is viewed as a constant in so far as he believes it to act consistently contrary to reason."
In fact, Robbin's chapter on Gracian is titled "The Exploitation of Ignorance." Gracian's maxims establish "a sharp distinction between the elite and the necios [that is, fools]." Assuming that most people are fools who act contrary to reason is obviously something quite different from assuming perfect expectations. For that matter, the prudence of a courtier seeking to gain power over others is something quite distinct the foresight required of a policy professional acting ostensively on behalf of the public welfare.

That metaphorical and Utopian notions of laissez faire and natural equilibrium have managed to persist and even prevail in economics -- impervious to Hutchinson's warning (or Keynes's) -- is testimony to the perceptiveness of Gracian's estimate of human nature.
_______________________

John Maynard Keynes, A Tract on Monetary Reform (1923)
Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.
Baltasar Gracian, Oráculo Manual y Arte de Prudencia, Maxim 138 (1647), English translation: The Art of Prudence.
The Art to let things go as they can go, especially when the Sea is tempestuous. 
There are Tempests and Hurricanes in the life of man. It is Prudence to put into a Haven, to let them blow over. Most commonly the Remedies increase the Evil. When the Sea of humours is in agitation, let Nature work; if it be the Sea of Manners, leave it to Morality. There is as much skill required in a Physician, in not prescribing, as in prescribing; and sometimes the excellency of the Art consists in applying no Remedy. The way then to calm popular gusts, is to be quiet. Then to yield to the times, will get the victory afterwards. A Well will be troubled if it be in the least stirred, and its water becomes clear again, by ceasing to dabble in it. There is no better remedy for some disorders, than to let them alone. For at long run they stop of themselves.
Gracian,  Oráculo, French translation: « L'homme de cour »
L’art de laisser aller les choses comme elles peuventsurtout quand la mer est orageuse.
Il y a des tempêtes et des ouragans dans la vie humaine; c’est prudence de se retirer au port pour les laisser passer. Très souvent les remèdes font empirer les maux. Quand la mer des humeurs est agitée, laissez faire la nature ; si c’est la mer des mœurs, laissez faire la morale. Il faut autant d’habileté au médecin pour ne pas ordonner que pour ordonner ; et quelquefois la finesse de l’art consiste davantage à ne point appliquer de remède. Ce sera donc le moyen de calmer les bourrasques populaires, que de se tenir en repos ; céder alors au temps fera vaincre ensuite. Une fontaine devient trouble pour peu qu’on la remue, et son eau ne redevient claire qu’en cessant d’y toucher. Il n’y a point de meilleur remède à de certains désordres que de les laisser passer, car à la fin ils s’arrêtent d’eux-mêmes.
Gracian, Oráculo
Arte de dexar estar. 
Y más quando más rebuelta la común mar, o la familiar. Ai torbellinos en el humano trato, tempestades de voluntad; entonces es cordura retirarse al seguro puerto del dar vado. Muchas vezes empeoran los males con los remedios. Dexar hazer a la naturaleza allí, y aquí a la moralidad. Tanto ha de saber el sabio médico para recetar como para no recetar, y a vezes consiste el arte más en el no aplicar remedios. Sea modo de sossegar vulgares torbellinos el alçar mano y dexar sossegar; ceder al tiempo aora será vencer después. Una fuente con poca inquietud se enturvia, ni se bolverá a serenar procurándolo, sino dexándola. No ai mejor remedio de los desconciertos que dexallos correr, que assí caen de sí proprios.

Why the Popularity of Piketty?

The contributors to the Guardian symposium on this question all missed what I think is the main reason: people who buy (and may also read) books in the US (at least) love fact-filled disquisitions about the long sweep of history.  Remember Guns, Germs and Steel?  On a more econ-ish note, This Time Is Different?  The length and factual detail of Capital in the Twenty-First Century, combined with its multi-century and multi-country scope, makes it that much more attractive.

If Angus Maddison had ever written a tome for the general reader, it would probably have been a mega-success.

In other words, while the style and politics of Piketty may have played a part, these aspects alone predict thousands of best-sellers.  Other filters are more important.

Of course, luck always plays a role too.  Avoid overfitting, especially when n is very small.

The Hours of Labour and the Problem of Social Cost

Peter Dorman commented:
[T]here has been unprecedented economic growth (as I and other textbook writers have defined it) over the last few centuries, and there have been massive increases in environmental stress over the same period. Does this mean that the two are necessarily yoked, and that the hypothetical possibility of increased growth and decreased environmental burden is a chimera? Well, if you want to make that argument you have to make it, not just assert it.... 
No, I don't want to argue that it's an unalterable causal relationship. I want to argue something much more subtle -- that the relationship is institutionally constrained. We can't keep doing the same things and expect different results. Nor can we solve a problem using a discourse that systematically excludes a key variable -- one might say the key variable.

Here is my explanation of the exclusion of that variable. I hope you are open-minded enough to give serious consideration to my explanation of the argument I have made rather than demand an explanation of an assertion I didn't make.

The Hours of Labour and the Problem of Social Costs outlines what I call an ellipsis (...) in the conventional analysis of what are called externalities, social costs and/or market failures. A proper ellipsis leaves out words that are unnecessary to the meaning of the passage. The paper is concerned with a theoretical ellipsis that leaves out the core variable and substitutes "simplifications" that evade one of the most crucial issues, especially with regard to cumulative effects over the long period.

I have expanded on the analysis and particularly on the historical context in my "supply creates its own demon" series here over the past few months. I can't expect you to have read or to agree with everything I have written but if you want to challenge my assertions, you are welcome to criticize things I have actually asserted.

Misunderstanding What Economic Growth Means

I would probably have no argument with Peter Dorman if he said that "degrowthers" have a different understanding of what economic growth means, with which he takes issue. By the way, I don't consider myself a "degrowther" -- I consider myself a critic of the growth paradigm. The growth critics I know have a very sophisticated understanding of what economic growth means. Please leave the condescension in the country club locker room where it belongs.

Roefie Hueting, for example, is the former head of the Department for Environmental Statistics of Statistics Netherlands. He developed the Sustainable national income, (SNI) indicator. Peter Victor's book, Managing without Growth, starts out with a comprehensive discussion of the idea of economic growth, including a section reviewing economists who question growth, such as John Kenneth Galbraith, H. W. Arndt, Ezra Mishan, E. F. Schumacher, Kenneth Boulding and Herman Daly. I would add, very prominently, Nicolas Georgescu-Roegen and Simon Kuznets.

Not all these economists have the same understanding of economic growth or the same objections to what it means, how it is calculated and whether it is sustainable. But on the other side there is this kind of claim that seems to typify standard economic thinking:
If the elasticity of substitution is not constant, what is crucial is what happens to the elasticity asymptotically as resource input goes to zero. In these cases the produced input is sufficiently substitutable for the natural resource that the decrease in supply of the natural resource can be compensated for by an increased supply of capital. Of the two cases, the Cobb-Douglas case is clearly the most interesting for there natural resources are essential in the sense that some input of the natural resource is required for production (the isoquants never do hit the axes). But a small input of natural resource can be compensated for by a sufficiently large input of capital, and whether that is feasible for the economy depends simply on the relative shares of the two. -- Joseph Stiglitz, "Neoclassical Analysis of Resource Economics."
Notice how much work the word "capital" does in that paragraph without a clear definition of what "capital" means?

One of the "misunderstandings" I repeatedly hear attributed to critics of the growth paradigm is that we don't take into account "dematerialization" and the value of intangible products and services. That is pure bunk. These magical solutions have been studied intensely by critics. To make a long story short, the issue is an empirical one and the proponents of dematerialization and intangibility haven't delivered the goods. Miniaturization may seem like a form of dematerialization but, in fact, the manufacturing process often involves more, not less material throughput.

The shift from products to services is also no magic bullet because the service providers come from households that use the income from service work to purchase products made from stuff (possibly in China). Many of the presumably "new" services in the economy are actually old services that used to be performed directly by households and the industrial provision of services, even though it is less material intense than the manufacture of products is usually MORE material intense than the direct household production of those services.

I hear these refrains of substituting capital for natural resources, miniaturizing products and substituting services for manufactured goods all the time. And I read empirical analyses by critics of growth that question the sweeping claims about how easy it is to dematerialize the GDP. And let's be clear, we are talking about less material throughput, period, not only less material throughput per unit of GDP. If absolute material throughput increases while relative throughput decreases the bottom line is that absolute throughput has increased. This is a relentlessly empirical question. What counts is what happens not what "could" happen (ceteris paribus).

Why Paul Krugman Is Wrong about the Cost of Climate Protection, and Why it Matters

Who’s right, those who think that economic growth can’t coexist with protection of the climate, or Paul Krugman who says “saving the planet would be cheap and maybe even come free”?  Alas, neither, but for different reasons.

I’m completely on Krugman’s side when it comes to debunking the degrowthers.  I’ve already written on this before; here I’ll just say that this view, prominent in parts of the Left, is based on a misunderstanding of what economic growth means.  Those who cling to this belief could benefit from reading either Krugman’s introductory textbook or mine.  This is an issue we agree on.

But can it be true that carbon policy practically pays for itself?  Have renewable sources of energy come down so far in cost and availability, and are the co-benefits of mitigating climate change so large, that staying under 2º is virtually a freebie?  Krugman cites two recent studies, one from The Global Commission on the Economy and Climate, the other by a team of researchers at the IMF, that say yes.

Let’s take them one at a time.  The GCEC, a blue ribbon panel under the leadership of political and business leaders as well as economists, comes to its conclusion by estimating the cost of a set of investments that they believe will achieve an emissions level in 2030 consistent with a longer run 2º path.  It’s not possible to fully evaluate their claims, since their report is based on technical papers that haven’t been made public yet, but even a quick reading reveals a number of telltale elisions and misconceptions.

The first and most important is that they don’t model a program to keep expected global temperature increases within 2º, not even over the next 15 years (which take us to 2030).  This would depend on staying within our carbon budget, and cumulative carbon emissions are measured by the area under the annual emissions curve, not by the emissions at some point in time, like 2030.  Thus the program being costed is not the same as the one the IPCC says we need to be on.  Since the putative GCEC mitigation impacts are the result of a large and gradually developing investment program, they are backloaded—meaning that their pathway to 2030 greatly over-accumulates greenhouse gases during the interim.  (For a somewhat fuller explanation, see this.)

Second, like most in the this-will-be-cheap crowd, they get a lot of their climate mitigation from forest and agricultural policies that sequester carbon in trees and soils.  It’s funny: everyone seems to think this is a great idea but forest ecologists, who have pointed out for years that the true sequestration benefits of forests depend on changes in the steady-state forest cover, which is absolutely unknown, and that both forest and soil carbon sinks will be altered by climate change itself.  I’ve written about this too.  Add to these observations new evidence concerning the impact of forest cover on the earth’s albedo and the greenhouse effects stemming from the interaction between forest-generated volatile organic compounds and atmospheric fossil fuel emissions, and the case for reforestation as climate mitigation collapses.  More forest and healthier soils are great, but to forestall catastrophic climate change you’ve got to keep fossil fuels in the ground.

Third, this report puts a lot of stress on the co-benefits of reduced fossil fuel use.  That’s excellent in itself and important to broadcast, but they take it a step further.  Using monetary measures of the value of lives saved due to reduced pollution, they turn this into an “economic” benefit which they then deduct from the economic costs of measures to cut fuel use.  Now, it happens I wrote a book some time back about the problems with the methods used to produce these numbers, and nothing has transpired since to cause me to change my views.  In addition, however, it is misleading to treat the costs economists attach to premature deaths that are said to reflect our diminished utility from risk as equivalent to real, honest to god money.  No money will actually change hands because you don’t like to breathe polluted air.  No one will be able to pay bills with it, purchase assets with it or do any of the other things people do with the stuff we call money.  When you make claims about the economic impacts of policy—its effect on jobs and economic growth—it’s a distinction you want to take note of.  Again: the health benefits of burning less carbon are real, and we need to spread the word, but converting everything to dollars is misleading and actually stifles the message.

Finally, costing a carbon mitigation program on the basis of the cost of additional investments is suspect.  For one thing, it appears to assume that each extra BTU of renewable energy means one less BTU of fossil fuel, but that is an improbable upper limit.  The truth is, the only way we’ll keep carbon in the ground is either by taxing it or requiring permits to extract it; cranking out renewables by themselves, virtuous as it is, doesn’t do the job.  In fact, it is unlikely that the timetable that results from going on a carbon diet—if it adheres to a meaningful budget constraint—will match the timetable of expanded renewable supply; we’ll have to cut back on the first faster than we can fill in with the second.  So what gives?  That’s precisely where the conflict between economic convenience and the climate imperative lies.  But it’s worse than that.  The most disruptive cost of dramatically and quickly reducing our use of fossil fuels is its effect on a wide range of existing capital assets, not only fossil fuels but investments that begin to pay a negative return when energy costs shoot up.  The question is whether the world economy is better prepared for the effects of a price crunch of this sort today than it was in the 1970s when OPEC set off a massive shock.  Yes, we are all more efficient today, but we are far less efficient compared to where we need to be to deal with climate change than we were pre-OPEC compared to where we needed to be to cope with subsequent oil price volatility.  And the OPEC squeeze was a one-off, where the screws of carbon policy, if they’re applied correctly, will tighten and tighten for decades.  As far as I can tell, GCEC assumes that no existing investments, except for a small amount in the energy extraction sector, will need to be written down or off.  Good luck with that.

Now on to the IMF.  Guess what?  They do the same thing with co-benefits.  Yes, it’s important to note that burning less coal in particular (and particulate) will be wonderful for our lungs and the bodies that house them.  Unfortunately, the researchers also take the step of monetizing these benefits using the same dubious value of life numbers, and then treating them as if they could be deducted from the financial costs of higher fuel prices.  No: health is not fungible the way money is fungible.  Sorry.

Meanwhile, a huge source of the economic benefit they ascribe to carbon levies is the opportunity they offer to cut income and business taxes.  Their general equilibrium models tell us that we’ll get trillions of dollars of economic growth from this.  Of course, since the models assume that all economies would be perfectly efficient in the absence of income and similar taxes and suffer lamentably as a result, they generate large gains from tax cuts.  In the real world, however, the weight of evidence does not support the proposition that countries with lower taxes, ceteris paribus, perform better economically.  (And the very use of ceteris paribus here is questionable, since the determinants of political and economic outcomes are many and intricately interconnected.)  In short, the IMF’s economic benefit from taxing carbon and cutting taxes on everything else is the product of an ideology that reasonable people—like Paul Krugman—would no doubt reject if it were put to them directly.

My apologies for piling on so much detail, but (1) it’s not nearly as much as these questions really need, and (2) that’s where the devil is.

So what does it all mean?  And do arguments like mine just end up playing into the propaganda of the Koch brothers and other climate villains?  Wouldn’t it be better just to say that protecting the climate will be cheap and leave it at that, whether or not it’s true?

Believe me, I truly wish we could get climate protection on the cheap.  It would so much easier that way, and to be honest, I don’t want to pay the price any more than anyone else does.  Every time I fly somewhere in a plane or hop in my car to get to a distant trailhead, I think about what I might have to give up if the world gets serious about minimizing the risk of a climate catastrophe.  And if I turn out to be wrong—if it can be shown that my analysis is based on poor information or faulty thinking, and the costs we will all have to pay are minimal—I will gladly, happily admit to error.

If I’m right, though, there are two reasons for not downplaying the true costs of keeping carbon in the ground.  One is that we will miss the opportunity to anticipate and manage economic disruption, thereby making it that more disruptive.  There is a small army of smart, talented economists wasting their time trying to calculate a specious “social cost of carbon”, and we would all be a lot better off if they could switch to making realistic forecasts of where carbon budget constraints will likely pinch, so we can plan ahead.  Over the next several decades, the need to proactively adapt to climate policy will be as great as the need to adapt to climate impacts.

The other cost is political.  If Krugman is right, once we get past the denialists the coast is clear.  Since policy will be cheap, maybe even a net contributor to profits and growth, opposition will melt away.  Businesses will be happy, workers will be happy, and the only question will be, why did it take us all so long to get happy?  If I’m right, getting past denialism is just the beginning.  As rapid fuel price increases loom, businesses will mobilize to stop them, or at least to try to game the policies so that other people have to pay but not them.  Workers, facing the threat of dislocation, will join these demands, as those in the coal sector have already done—coal currently being on the front lines of policy.  We will need a permanent, massive mobilization of forces fighting on behalf of the common interest.  That’s a challenging political forecast, but if a substantial portion of private wealth is vulnerable to writedown if climate policy gets real, there’s no other way to do it.

POSTSCRIPT: For those who think I'm exaggerating, that I'm just a doom and gloomer looking for an issue, please explain the bipartisan support in Congress for and Obama's signature of the 2012 European Union Emissions Trading Scheme Prohibition Act.  The EU ETS is widely acknowledged to be too weak to have a measurable impact on fossil fuel use, but it's way too strong for business interests in the US.  I guess they hadn't read the studies showing how taxing carbon practically pays for itself.

Saturday, September 20, 2014

Don't Pay Any Attention -- Paul Krugman edition

"Don't pay any attention..." [correction: this is not a quote from Krugman but Mark Thoma's characterization (correct, in my view) of Krugman's argument]

This is advice from Paul Krugman in his column Errors and Emissions. Professor Krugman obviously hasn't paid any attention to the analysis underlying the critique of "growth".

Lovely.

I teach this stuff at university. I pay a great deal of attention to arguments that the "strong measures to limit carbon emissions would have hardly any negative effect on economic growth, and might actually lead to faster growth."

Krugman says "This may sound too good to be true, but it isn’t. These are serious, careful analyses." If, as Krugman suggests you don't pay any attention to the critiques, you can just take his word for it that these are "serious careful analyses."

The fact is, though, that "serious careful analysis" would pay close attention to criticism. These too-good-to-be-true sounding arguments don't pay any attention to the criticism. They are not serious and careful analyses.

Don't pay any attention to what Roefie Hueting wrote about asymmetric accounting entries 20 years ago. Don't pay any attention to what Nicholas Georgescu-Roegen wrote about energy and materials 40 years ago. Don't pay any attention to what Simon Kuznets wrote about national income accounting 60 years ago. Don't pay any attention to what John Maurice Clark wrote about overhead cost shifting 90 years ago. Don't pay any attention to what Jevons wrote 150 years ago about fuel efficiency and consumption. Don't pay any attention to what Tim Jackson and the U.K.'s Sustainable Development Commission wrote about prosperity without growth 5 years ago.

Just don't pay any attention.

The corporate bureaucrats have your best interests at heart and have everything under control. Nothing can go wrong... go wrong... go wrong...

Move along, now. Nothing to see here.

Update: David Nemerson of Baltimore, MD posted the following comment to Krugman's column. It has received 67 "recommends", so far (don't pay any attention to David or to what Bobby Kennedy said 46 years ago):
Until we break the fetish of growth, we are in for a very bumpy ride indeed. Bobby Kennedy's critique of GDP stated it beautifully in 1968: 
"It counts napalm and counts nuclear warheads and armored cars for the police to fight the riots in our cities. It counts Whitman's rifle and Speck's knife, and the television programs which glorify violence in order to sell toys to our children. 
Yet the gross national product does not allow for the health of our children, the quality of their education or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials.
It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything in short, except that which makes life worthwhile.
And it can tell us everything about America except why we are proud that we are Americans."

Rest of the quote here.

Friday, September 19, 2014

MAXimizing Utility?

At MaxSpeak, Max responds to comments on his earlier posts on Universal Basic Income.

Bud Meyers wrote:
With ever more robotics and automation putting people out of work, how will they live without a Universal Basic Income, when human labor becomes obsolete?
To which, Max replied:
I totally disagree with the idea that jobs will be displaced by automation. The composition of jobs will change, but there is still quite a bit of useful work to be done. People were talking this way in the 1950s. There is always more automation, and always other kinds of new jobs.
Whoa, Max! You just invoked the lump-of-labor fallacy claim!

Logically, the premise that “there is still quite a bit of useful work to be done” is true by definition. Empirically, the statement is vacuous. That doesn't mean it is untrue, just that it has no empirical content. The effort to fill it with pseudo-content leads inevitably into self-contradiction, as shown by the “dispute” in the 19th century between Cairnes and Thornton over the wages-fund doctrine. See "Ceteris paribus, Dr. Jekyll tans his own Hyde"

The methodological issues here don’t have to do with whether or not there is “work to be done” but with uncertainty, rational expectations and the fundamental assumption of “maximizing utility” (stated by Nassau Senior as “That every man is desirous to obtain, with as little sacrifice as possible, as much as possible of the articles of wealth.”) See my new post "On Deducing Faith and Redemption from Usury with the Help of Automata."

On Deducing Faith and Redemption from Usury with the Help of Automata

"That every man is desirous to obtain, with as little sacrifice as possible, as much as possible of the articles of wealth." -- Nassau Senior, 1827
In "Expectation and Rational Conduct" (1937) Terence Hutchison argued that Senior's "first fundamental proposition" shared "one remarkable characteristic" with "almost all" formulations of the utilitarian doctrine: "they appear further to postulate, and only are applicable if the further postulate is made, that all expectations are perfectly correct."

Now, this perfect expectation postulate can be -- and has been -- shrugged off as a merely heuristic "convenient approximation" that enables the economist "to study in isolation, tendencies which in the world of reality operate with many others" (Robbins, 1935). But, as Hutchison emphasized, the consequences of such a "simplification" are not so easily waved aside. He cited Frank Knight:
"With uncertainty absent, man's energies are devoted altogether to doing things; it is doubtful whether intelligence itself would exist in such a situation; in a world so built that perfect knowledge was theoretically possible, it seems likely that all organic readjustment would become mechanical, all organisms automata."
Hutchison followed this quotation with the observation that it is misleading to attribute rationality to "this sort of conceptual marionette" because the decision process becomes superfluous when results are known beforehand. In one example, he compared the logical impossibility of perfect expectation to the liar's paradox: "A person's conduct cannot both be given to someone else who may adjust his own accordingly, and still be adjustable by the person."

1937 was a banner year for economic articles addressing uncertainty. In addition to Hutchison's article, the following were published: Coase's "The Nature of the Firm," Hayek's "Economics and Knowledge" and Keynes's response to critiques of his General Theory in The Quarterly Journal of Economics. In his article, Keynes observed that uncertainty about the indefinitely distant future renders the accumulation of wealth "a peculiarly unsuitable subject for the methods of the classical economic theory." Of course that "peculiarly unsuitable subject" happened to be none other than the very one the classical theory purported to illuminate -- with, as Senior put it, "certainty and universality."
"Exactly a year before Nassau W. Senior discovered at Manchester, that the profit (including interest) of capital is the product of the last hour of the twelve, he had announced to the world another discovery. 'I substitute,' he proudly says, 'for the word capital, considered as an instrument of production, the word abstinence.'" -- Karl Marx
Abstinence was the basis of Senior's theory of interest. Interest is a payment to the lender of money for the service of abstaining, for the time being, from consumption. According to Waterman, Senior "was the most important writer on scope and method among the classical economists, and the one whose work was most influential for the twentieth century development of economic methodology."

Some 26 years after Senior delivered his inaugural lecture at Oxford, Cardinal Newman, in his inaugural lectures at the Catholic University of Ireland, rebuked Senior for the presumptuousness of the claims he had made on behalf of political economy. Newman characterized Senior's argument as "just so far true, as to be able to instil what is false."

Newman quoted Senior's assertion that "The endeavour to accumulate the means of future subsistence and enjoyment, is to the mass of mankind, the great source of moral improvement." Newman interjected to exclaim that Senior had rated the pursuit of wealth as "not merely a source, but the great source" of not merely "social and political progress—such an answer would have been more within the limits of his art,—no, but of something individual and personal, 'of moral improvement.'"

That was only the warm up. To Senior's claim that "No institution could be more beneficial to the morals of the lower orders... than one which should increase their power and their wish to accumulate..."  Newman observed that this excluded Christianity, "for it expressly says, 'Lay not up to yourselves treasures on earth... for where thy treasure is, there is thy heart also."

"But it is not enough that morals and happiness are made to depend on gain and accumulation," Newman exclaimed, continuing:
"...the practice of Religion is ascribed to these causes also, and in the following way. Wealth depends upon the pursuit of wealth; education depends upon wealth; knowledge depends on education; and Religion depends on knowledge; therefore Religion depends on ‘the pursuit of wealth.'"
Thus did Nassau W. Senior deduce faith and redemption from usury, while redefining usury as "abstinence." Medieval canon law strictly condemned usury and prescribed excommunication as the punishment for usurers, excluding them from the sacraments of the church and the from society of other Christians. How did such a remarkable doctrinal reversal, from sin to sacrament, come about?

The history of double-entry bookkeeping offers a clue. Surely one of the motivations for early modern merchants to adopt the novel and challenging technique was to "prove an alibi" against suspicions of usury. Some of the financial instruments for evading the prohibition were complicated, to say the least:
"The canonist doctrine on usury had a profound influence on business practices, since interest could not be charged openly but had to be concealed under some form or other. As a result of the usury prohibition, bills were never discounted but were bought at a rate of exchange which fluctuated up and down according to the conditions prevailing in the money market. There is no doubt that interest was received by the banker who invested his money in the purchase of bills, for a hidden interest was included in the rate of exchange. Because of this subterfuge, the structure of the money market was such that exchange fluctuations were caused either by a change in the rate of interest or by a change in the terms of international trade."
... 
"The ledgers of medieval bankers do not contain any account called Interest Income. Nor is there any account for Interest Expense. It is true that the Italian merchant-bankers often paid interest on time deposits, but it was called deposit, discrezionedono (gift), guadagno (gain), or provedigione (commission). The use of the word 'interest' itself was avoided like the plague. 
True, interest was concealed in the exchange rates, but the presence of the interest factor was boldly denied. The merchants argued -- and the canonists agreed -- that exchange transactions did not involve a mutuum or a loan of money for certain gain. It is quite true that the profit on individual exchange transactions was uncertain.
And so, we return at last to uncertainty, this time as an alibi for the certain gain of usury. But I have interrupted de Roover's narrative. There is more:
"As the analysis of our data reveals, it did happen that occasionally the lender lost. Nevertheless, the reasoning of the canonists was fallacious: they overlooked an essential point, namely, that the presence of the time factor tipped the scales in favor of the banker. While he suffered a few losses, the banker was bound to gain on most transactions, if he was a clever and cautious manager. Losses occurred only when the exchange rates were not in a position of equilibrium. Such a condition could not persist over a long period of time, for the economic forces of the money market automatically tended toward the restoration of equilibrium."
de Roover possibly overstated the case for the automatic restoration of equilibrium. But his point remains valid that the usual tendency toward equilibrium in the foreign exchange market favored the banker "if he was a clever and cautious manager."

Sections 5 and 6 of Hutchison's article address, respectively, "Perfect Expectation and Equilibrium" and "The Assumption of a 'Tendency' Towards Equilibrium." "The position of equilibrium," he argued at the beginning of section 6, "has always been the very central concept of economic analysis." In section 5 he had cited Oscar Morgenstern's argument that the postulate of perfect expectations "may give a nonsensical indeterminate situation the very reverse of equilibrium." Conversely, Knight, Hicks and Pigou argued that the postulate of perfect expectation is necessary for equilibrium theory.

Leaving aside some ostensively universal political economy and thinking instead in terms of Venetian merchant-bankers' interest on loans -- interest concealed within rates of exchange -- uncertainty, perfect expectation and the tendency toward equilibrium all play their roles in assuring both probable profit and usurious deniability to the bankers. The probability of gain is a qualitative one and thus not calculable. All the better to allay suspicion.

This just in: At the end of an appendix to Significance and Basic Postulates of Economic Theory, Hutchison remarked, "It must always be remembered that laissez faire and equilibrium doctrines had their origin in rationalistic Utopia-building." In the footnote to that comment, he cited the 1931 article by S. Bauer, "Origine utopique et métaphorique de la théorie du “laissez faire” et de l’équilibre naturel." Below is an abstract of that article:
9538. BAUER, STEPHANE. Origine utopique et métaphorique de la théorie du “laissez faire” et de l’équilibre naturel. [Utopian and metaphoric origin of the theory of 'laissez faire' and of natural equilibrium.] Rev. d’Êcon. Pol. 45(6) Nov.-Dec 1931: 1589-1602.
A re-examination of the origins of laissez faire gives rise to three observations: (1) the theory of laissez faire was originally conceived as a utopia; (2) it developed as an abuse of a metaphor; (3) this utopian metaphor has perpetuated itself into the 19th century in the guise of a theory of equilibrium. Economic laissez faire was utopian, i.e. far from the facts, and purely intellectual in origin, since both in France and England the corn markets of the 18th century were regulated. The metaphoric use of laissez faire carried over from the Pyrrhonean theory of medicine was current not only in Boisguillebert, d'Argenson, Gournay, and the Marquis of Casaux but is found in and old Spanish book by Balthasar Gracian, Oraculo Manual (1647) which was translated into French and was very popular in the 18th century. Indeed the whole concept of the sovereign and perfect character of nature can be traced through the Renaissance back to the Stoics. The medical analogy marks the work of the Physiocrats, of Adam Smith and of Cournot. Rodbertus protested against this point of view by setting "anthropocracy" in opposition to "physiocracy." Further protests are coming from those who explain economic phenomena in terms of economic institutions rather than in terms of deviation from a rigid system of equilibrium.

Wednesday, September 17, 2014

The "Ceteris Paribus" Assumption

From The Significance and Basic Postulates of Economic Theory by T. W. Hutchison (1938, 1960), pp. 40-46:
As an example of the use of the ceteris paribus assumption we may take the proposition "If the price at which a good is sold rises, ceteris paribus the amount of the good demanded declines." Is this an empirical generalisation which can conceivably be false without any contradiction, or is it an analytical-tautological proposition? 
This, usually, is not made clear, and perhaps such propositions are sometimes meant in one way, sometimes in another. One can only ask in each particular case whether the validity of the ceteris paribus proposition in question depends on facts, or whether, on the other hand, the denial of it simply shows that one does not understand by the terms "rise in price" and "amount demanded" what the language of economists understands. 
If the proposition "If the price at which a good is sold rises, ceteris paribus the amount of the good demanded declines" is an empirical generalisation, so it can only have a clear scientific meaning if it is indicated under what conditions it would be true, or under what false. Further, it is desirable that the difference be shown between this empirical generalisation (with ceteris paribus) and the other empirical generalisation, "If the price at which a good is sold rises the amount of the good demanded declines" (without ceteris paribus). 
Ceteris paribus propositions can be interpreted in this way. But if they are to be so interpreted—as empirical generalisations—then they are usually very vaguely and unclearly formulated. For no attempt is made, usually, to indicate under what conditions they are true and under what false, and the meaning of the vital qualification "ceteris paribus" is left hopelessly imprecise. The ceteris paribus assumption, just as much as any other, must be precisely formulated if the propositions it qualifies are to have any clear meaning. The intention of the assumption obviously is to lessen the falsifiability of the too often falsified generalisation "If the price of a good rises, the amount sold declines." But exactly how far is its falsifiability thus lessened, and if it remains an empirical proposition, what conceivable possibilities of falsification remain? 
On the other hand, it seems more probable that ceteris paribus propositions are frequently treated as analytical-tautological propositions, the example taken in this case explaining a relation between the definitions of "rise in price" and "amount demanded" at different points on a demand curve of a particular shape—a purely logical or geometrical relation. Then it is inconceivable that its truth or falsity (as against its applicability) can be established by any facts, since it is without factual content. In this case one simply determines whether, in fact, the ceteris paribus assumption is true or false, by observing whether or not the price has risen appropriately or not—a circular procedure. This appears to be the interpretation favoured by Menger, though it involves a very elastic conception of "cetera." For example, if the well-known case of poor people buying more bread when the price of it rises in no way falsifies our proposition, this involves a considerable stretching of the assumption "ceteris paribus." 
Thus interpreted the ceteris paribus clause is an accessory assumption of pure theory, and ceteris paribus propositions may be analysed in the same way as the propositions of pure theory have been. The ceteris paribus assumption makes out of an empirical proposition that is concerned with facts, and therefore conceivably can be false, a necessary analytical-tautological proposition. For a mathematical solution (by tautological transformations) the number of equations must be equal to the number of unknowns. The ceteris paribus assumption sweeps all the unknowns together under one portmanteau assumption for a logical "solution."
In Physics and Chemistry, where there are far more discovered empirical regularities, the ceteris paribus assumption is not used in the same way. For if the assumption is broadly true, or if, as is rather the case, the "cetera" in the natural sciences themselves act in accordance with known laws, then the ceteris paribus assumption is more or less a given one, and a true premise can always be dropped. For in a certain sense it is only necessary to make an assumption when one does not know it is true, or knows that it is untrue. This is the peculiar dilemma—apparently unique throughout science—of the "isolating," "assumption-making" procedure of economic theory where there are few empirical generalisations known to be true 
In the natural sciences certain fundamental propositions can be taken either to be analytical-tautological or to be empirical generalisations, exactly as the ceteris paribus propositions may be so taken. For example, originally the proposition "All gases expand on warming" was probably arrived at by empirical experiments. But if to-day an experiment was made with something which as regards the other ways in which it was tested behaved like a "gas" but did not expand on warming, one would at first be inclined to suggest that some mistake had been made in the experiment. But if after repeated experiments this "gas" did not expand, scientists would be faced with a choice. Either they must say "Our law that all gases expand on warming is destroyed, and we must find a new law," or they could say "This stuff which does not expand on warming is no 'gas ', for by definition a 'gas 'must expand on warming; we must find some other name for this." The choice of this second course on all conceivable occasions would mean that the proposition "All gases expand on warming" was not an empirical law at all, but an analytical-tautological definition which was always true because it was not allowed to be false. From the mere wording and form of the proposition one cannot say whether it is the one or the other. One can only find out by a test case when scientists are forced to choose one alternative or the other. 
According to Edgeworth, "The treating as constant what is variable [e.g., supply, margin, wages-fund] is the source of most of the fallacies in political economy,"  and it is the danger of the ceteris paribus assumption that it particularly facilitates such fallacies. It is quite probably true that in more cases than not a rise in price is in fact followed by a decrease in demand, but this of course might not be so; and whether it is so or not can only be decided by statistical investigation. Our proposition with ceteris paribus does not tell us this. In fact the ceteris paribus clause seems sometimes so to be used that one might equally significantly and correctly advance the proposition that ceteris paribus a rise in price is followed by an increase in demand, as the proposition that ceteris paribus it is followed by a decrease. "Ceteris paribus this follows that" seems to come to mean simply "In many cases this follows that," and however often it may not, the reply is that the proposition only said "in many cases" (or ceteris paribus), and this was simply one of the other cases (or "ceteris paribus" did not hold). 
In the recent developments of the "dynamic" pure theory of employment the ceteris paribus assumption appears sometimes to have been applied to propositions which standing alone (without "ceteris paribus") are quite probably more often empirically false than true, but when it is added are meant to get away with some kind of exact and significant empirical content. 
Mr. Keynes gives an example of the use of the ceteris paribus clause on these lines. He contrasts the two propositions: (1) "A decreased readiness to spend... will ceteris paribus increase investment," and (2) "A decreased readiness to spend... will ceteris paribus diminish employment." Are these empirical or analytical propositions—that is, what is the precise content of "ceteris paribus"? If they are empirical, then it is difficult to see what the qualification "ceteris paribus" can mean other than "usually." Then we have two propositions: "A decreased readiness to spend will usually" either (1) "increase investment" or (2) "diminish employment"—two rather vague impressionist generalisations; and though one may be more often true than the other, neither is of much scientific value compared with statistical investigations as to what, in fact, does follow a decreased readiness to spend in. different cases, pending the results of which it seems difficult to justify an exclusive insistence on one as against the other. 
If, on the other hand, these propositions are analytical, there is of course no question of one being "true" and the other "false," and no particular reason for contrasting them, since neither says anything about what in fact follows a decreased readiness to spend. "Ceteris paribus" is simply used differently for the two equations. In the first total outlay is included among the "ceteris" that remain the same, so that a decrease in one division of it (consumption spending) mathematically implies an increase in the other division (investment). In the second equation employment on capital goods is assumed to remain the same, so that a decrease in employment on consumption goods mathematically implies a decrease in total employment. 
Either of these interpretations is possible and there may be others. In the first place such a use of the "ceteris paribus" clause leaves it quite ambiguous as to what kind of proposition is being put forward. In the second place it appears to give to what is either simply an empirically empty analytical proposition, or a very vague and statistically unsupported empirical generalisation, an air of some kind of precise and widely valid empirical content. 
We suggest that the ceteris paribus assumption can only be safely and significantly used in conjunction with an empirical generalisation verified as true in a large percentage of cases but occasionally liable to exceptions of a clearly describable type.
Conclusion (p. 163):
That ceteris paribus propositions are frequently hopelessly ambiguous and that the ceteris paribus assumption should be used less often and more cautiously.

Saturday, September 13, 2014

Tax Shaming from The Guardian

I bet Greg Mankiw really hates this:
America’s a great country. That’s why people from all over the world — including, lately and tragically, thousands of poor children from Central America — clamor to get in. So why are some of America’s wealthiest companies trying to get out? It’s simple, really — they don’t want to pay US taxes.
At this risk of having my internet name changed to ProGrowthConservative, I’m going to quibble a bit with The Guardian. I think the issue is not whether we keep the repatriation tax or not but whether we enforce the arm’s length standard. Medtronic is already getting a low effective tax rate without changing its tax domicile as is a host of the other companies noted here:
Instead, to avoid US taxes, they are parking their earnings offshore, often in tax havens like Bermuda and the Cayman Islands that levy no corporate income taxes. That tactic, which like the inversions is legal, is being employed by companies that position themselves as good corporate citizens — among them Apple, Coca-Cola, General Electric, Google, Microsoft, Nike and PepsiCo … One popular tactic is to grant patents or intellectual property rights to a subsidiary located in a tax haven, and then pay above-market royalties to that subsidiary, thus shifting profits from a high-tax jurisdiction to a low one.
Are the royalties really above the market rate? Would not the local tax authorities be able to challenge such royalties? Of course, the real issue is that these companies told the IRS that the fair market value of their intangible assets were low when the intangible assets were migrated to the low-tax jurisdictions. Are the good folks at the IRS properly enforcing section 367(d). But the real issue here is tax shaming:
But shouldn’t good citizens pay their fair share of taxes? Socially responsible investors and watchdog NGOs say tax avoidance carries risks for companies that care about their reputation, as all companies should. “It’s short-sighted,” says Adam Kanzer, general counsel and managing director of Domini Social Investments. “Companies like Walgreen’s run the risk of being seen as unpatriotic.” Just two years ago, the Illinois-based drugstore company sought and received tax breaks from the state government, and now it’s ready to leave. Domini this year filed a shareholder resolution to reform Google's tax-avoidance strategy. It said: “Even if they are within the law, aggressive tax minimization approaches pose regulatory, reputational and financial risks.”
This is the part that Greg Mankiw is going to hate. When I talked about the Walgreen proposed inversion, I wrote:
We need to do what the tax attorneys call a section 367(d) analysis. Let’s assume that the 5.5% operating margin being generated by these Walgreens stores can be decomposed into a 3% routine return versus a 2.5% royalty rate for the use of various intangibles (patents, trademarks, etc.). Hallman is suggesting that the Swiss affiliate could charge $1.8 billion per year in royalties. But under section 367(d), the Swiss affiliate would have to pay the U.S. affiliate the fair market value for the transferred intangible assets. What is a reasonable estimate of this fair market value? Is it closer to $20 billion or to $2 billion? I’m sure Walgreens could get some hack who pretends to be a valuation expert to argue for the lower figure. But if one looked at the balance sheet as well as the current market value for the equity of Walgreens and tried to deduce the market’s valuation of its intangibles, this figure would be closer to $40 billion.
Let me admit an error here – the fair market value was closer to $50 billion, which may be one reason why Walgreen did not go through with their proposed inversion. They realized that their investment bankers weren’t being straight with them in terms of the possible reduction in their effective tax rate. But let me close with a complaint about this Starbucks UK story. This story is due to Tom Bergin who was one of the few that got the Burger King story right. Tom wrote:
Like those tech firms, Starbucks makes its UK unit and other overseas operations pay a royalty fee - at Starbucks, of six percent of total sales - for the use of its ‘intellectual property' such as its brand and business processes. These payments reduce taxable income in the UK. McDonald's also charges its UK subsidiary a royalty for ‘intellectual property', although at a lower rate of 4-5 percent. The fees from Starbucks' European units are paid to Amsterdam-based Starbucks Coffee EMEA BV, described by the company as its European headquarters, although Michelle Gass, the firm's president in Europe, is actually based in London. It's unclear where the money paid to Starbucks Coffee EMEA BV ends up, or what tax is paid on it.
Let’s suppose the intercompany royalties ended up with the US parent. The IRS would argue that the 6 percent royalty rate was arm’s length as this is the rate paid by third parties. Its stores in North America are generating profit margins near 20 percent before these royalties so a 6 percent royalty rate leaves them with significant profits. The Starbucks 10-K, however, shows that operating costs in the EMEA region (mainly the UK and Germany for company owned stores) are much higher so that even under arm’s length pricing, their company owned stores will financially struggle. Besides why would a company shift income from a UK affiliate with a 20 percent tax rate to the US with its 35 percent tax rate? Tom Bergin and other reporters are doing admirable work but at times what they write does not make complete sense.

Friday, September 12, 2014

Financial Fraud and the Business Cycle: The Chinese Case

We read this morning of another instance of financial fraud in China, this time involving payola to journalists to influence their business coverage.  In fact, there has been a stream of reports suggesting dishonest accounting and misleading disclosures are widespread in Chinese finance.

I have a theory of financial fraud, loosely derived from Veblen’s Theory of Business Enterprise with a little Minsky thrown in; it goes like this:

There is always a lot of fraud in the world of corporate accounting and finance; it is very hard to prevent.  (a) The motive is strong.  Report higher earnings, attract more investment and credit, enjoy more opportunities to launch new projects or prop up old ones, boost asset values, make money.  (b) The restraints are weak.  As Veblen pointed out, a large portion of valuation is speculative in any case, based on prognostications of future profits.  There are insiders and outsiders, and insiders among the insiders.  The booty can be shared with those, like accountants, raters and reporters, who are ostensibly there to monitor probity.  Regulators are captured, politically and cognitively.

Of course, the problem with fictitious profits is that eventually events separate fact from fiction.  Companies that coasted on inflated earnings forecasts crash against the shoals of realized losses.  But this takes time, and meanwhile there are new companies, and new amalgams and spinoffs of old companies and new investment projects whose inflated valuations can bulk up portfolios faster than past disappointments can shrink them.  Red ink can be covered over if there’s enough black, even if the black is speculative and the red is real.

This works in the boom for two reasons.  First, there are lots of real profits being made, so inflated forecasts are (temporarily) validated and occasional losses can be absorbed.  Second, the proportion of new projects, whose valuation is entirely speculative, to past projects is higher.  Reality bites less.

All booms come to an end for one reason or another, and when they do the hidden world of fraud is exposed for all to see.  It’s no longer possible to sustain the pretense: the supply of funds to those who had been losing money all along is cut off, bringing about (literally) a moment of reckoning.

I would like to distinguish between the cyclical visibility of fraud and its actual cyclicality.  Fraud is exposed in the crash, but did it peak just prior to it and cause it to happen?  The general opinion, and this includes Veblen-Minsky, is yes.  Booms become frothy, and froth foments fraud.  Perhaps.  But I suspect the conditions conducive to financial fraud are always in place, and much of the fluctuation is about what we see, not what there is.

When the dotcom bubble collapsed at the beginning of the 00's we witnessed an epidemic of accounting fraud.  Remember Enron, Global Crossing and Arthur Andersen for starters.  The CDO deceptions of the mid-decade were exposed by the financial crisis of 2008.  No doubt accounting and rating standards deteriorated during the bubble years, but this is not to say they weren’t widespread all along.  Part of what changed is that the popping of the bubble removed the buffers that normally allow a bending and stretching of the numbers.

I doubt that this is a culture-bound hypothesis, true for the US but not, say, China.  The extraordinary Chinese investment-led boom of the past twenty years can obscure a lot of malfeasance, but if and when the boom ends we’ll find out that much of the wealth creation was fictitious.  Best-sellers will be written about brazen fraud in high places, as if this were unique to China and its final go-go years.  But while it's much easier to call out corruption after the money train has stopped, this doesn't mean that an upsurge of corruption stopped the train.

(Other things being elsewhere...) "It’s a ceteris paribus thing,"

Paul Krugman:
"It’s a ceteris paribus thing, just like supply and demand."
Hans Albert, "Model Platonism: Neoclassical economic thought in critical light."  Journal of Institutional Economics (2012):
"T. W. Hutchison... called attention to the significance of ceteris paribus clauses as a form of alibi..."
I'm eagerly awaiting the delivery from interlibrary loans of Hutchison's The Significance and Basic Postulates of Economic Theory (1938). I'm neither a philosopher of science nor an economic methodologist. It's just that I like to have a good idea of "the literature" before I barge in with my two cents worth.

But I am thinking that recognizing ceteris paribus as an "alibi" is very important. Let me explain: "alibi" means elsewhere but it doesn't necessarily specify where else. It could be anywhere else. To prove an alibi, one must present a convincing narrative that offers specifics. The catch-all ceteris paribus clause invoked by economists comes closer to the lame excuse sense of alibi. Alibi assumptions immunize hypotheses against critique and falsification by empirical evidence.

While awaiting Hutchison's book, an observation in a 1935 "Note on Tautologies and the Nature of Economic Theory" caught my attention. Hutchison didn't reject tautologies. They have a role to play in logic and "pure" theory. What Hutchison objected to was "certain claims for deductive theory which... appear excessive." Specifically, Hutchison cited "a failure to distinguish between implication and inference" as giving rise to such excessive claims:
"This distinction may be summed up by saying that implications take the form 'if p, then q', and inferences the form 'since p, therefore q'. The one shows formal connections, the other states conclusions about the real world. An inevitable implication is a tautology, and can, by its nature, no more prognosticate anything than can the multiplication table. An inference, on the other hand, requires some data to be known in order to establish a 'since'."
The IS-LM "ceteris paribus thing" is an "if p, then q" thing -- a tautology -- not a "since p, therefore q" thing. One cannot draw conclusions about the real world from it.

Thursday, September 11, 2014

London Sharks the Lump

Proof that economic journalists don't need to know any economics: Peter Coy is Bloomberg Businessweek's economics editor:
"Those who say that London sucks the vitality out of other cities are committing what economists call the lump-of-labor fallacy: that the amount of work to be done is fixed, so if one person gets a job then someone else is unemployed. The truth is that the rich young City traders everyone loves to hate are buying stuff made throughout the U.K."
Note to Mr. Coy: the real truth is that... according to the fallacy claim's implicit criteria, whatever anyone said about anything could be shown to be committing the lump-of-labor fallacy. You have committed the lump-of-labor fallacy by accusing others of committing the lump-of-labor fallacy!

Wednesday, September 10, 2014

Those fat monkeys

Because... Marat/Sade.
Those fat monkeys covered in banknotes
Have champagne and brandy on tap
They're up to their eyeballs in franc notes
We're up to our noses in crap
Those gorilla-mouthed fakers
Are longing to see us all rot
The gentry may lose a few acres
But we lose the little we've got
Revolution, it's more like a ruin
They're all stuffed with glorious food
They think about nothing but screwing
And we are the ones who get screwed