Wednesday, 18 November 2009

Close is enough for a cigar

Interesting but flawed discussion of Keynes and the failures of free market capitalism and contemporary economics in a book review by John Gray.

The book, 'Animal Spirits', is about the importance of integrating behaviourialist insights into the dominant rationality-based economics of today. People aren't rational in substantive ways; they're influenced by the animal spirits of the book's title. The rationalist assumptions that underpin contemporary economics need to be modified or complemented if the discipline is going to have adequate explanatory and predictive purchase. The authors believe that this will help us to identify and contain future financial crises.

But Gray argues that this improvement in the way we do economics won't be sufficient to make economics an effective predictive tool. We still won't have the wherewithal to see a crisis on the horizon and take evasive action.

Gray argues, and he finds support in Keynes, that nothing in Western economics can give us this predictive power: in Keynes words (and the title of the review): "We simply do not know!". And cannot know.

Keynes arrived at this conclusion after a consideration of the effectiveness of probability theory in predicting the future. There are risks out there and uncertainties: risks can have probabilities; uncertainties can't. However, there are so many uncertainties in play - some of them disguised as risks - that they render the probabilistic approach ineffective. It was this conviction, that the future is unknowable, that provided the foundation to Keynes's scepticism about markets. Gray, quoting Keynes:
...there was no way anyone could make forecasts. Future interest rates and prices, new inventions and the likelihood of a European war cannot be predicted: there is no ‘basis on which to form any calculable probability whatever...'

Working from this insight, Gray ascribes the recent crisis in the financial system - and the knock-on crisis in economics - not to a lack of appreciation of behaviouralist thought by the economics profession but to an inability to predict the future. Expecting the market to look ahead for us and direct us down the right path proved a disastrous approach as the market simply wasn't equipped to do that for us.
For Keynes, markets are unstable less because they are driven by emotion than because the future is unknowable. To suggest that the source of market volatility is unreason is to imply that if people were fully rational markets could be stable. But even if people were affectless calculating machines they would still be ignorant of the future, and markets would still be volatile. The root cause of market instability is the insuperable limitation of human knowledge.

(His argument over the course of the review happens to conflate free markets and contemporary economics. They're different things and it's possible to believe that one has greater predictive power then the other; personally I favour the former. But anyway.)

He also points out that the success of China refutes those evangelising for the universal applicability and unique efficacy of the free market capitalist model. China's doing well without most of what the free marketeers deem essential for economic success, most importantly free markets. It's also managing without one of the major amendments to the free marketeers economic constitution: the rule of law. He argues the success of China puts contemporary Western economics in its place, as 'culturally parochial, [...] its underlying concepts based on a few centuries of Western experience'.

So far, so dismissive. But I believe Gray overstates our ignorance of the future, its unknowability (a rather flippant quotation from Keynes carrying a weight that it wasn't designed to bear). Surely, the salient point about markets is not that they're always right about the future; rather, it's that they're right more often than any other method of prediction we've discovered.

More right in quite banal but important ways: Steve Jobs predicted people would want an iPhone; it turned out to be a wildly successful prediction; now we can predict that on-the-move interactivity is going to be a very big part of our technological future; other entrepreneurs will be making predictions on the back of this prediction. So small predictions become vindicated and support large predictions, which in turn create a whole lot of new small predictions as they begin to look good bets. This is the substructure, if you like, of modern markets, often obscured.

These predictions by entrepreneurs become predictions by providers of capital, share prices rise, capital flows. Some of it is spreadsheet-driven, some of it is intuitive (cf. the difference between free markets and rationality-based Western economics). But in the aggregate it provides a prediction (or set of predictions that form a consensus) about the future that can hardly be described as wholly unsuccessful, at least in terms of economic growth, which, in the most reductive way, is the end goal of the consensus.

Besides, it's simply not true to say that no-one forecast the financial crisis. To name three that got it right and either bolstered reputations or fortunes in doing so: Warren Buffett, Goldman Sachs, Gillian Tett. The problem was that these forecasters' views didn't become the consensus view. Why? Those old products of the animal spirit, hubris and cupidity, must take a good part of the blame.

The future, then, is neither entirely knowable nor entirely unknowable; but it is amenable to, at the very least, informed guesses. And it is the free market that both makes these guesses as informed as they possibly can be and brings them to our attention.

Even though he was writing about politics, it's Popper who for me conceptualises best why this should be the case: it's for the same epistemological reasons that Open Societies work better. Freedom of thought, freedom of expression, debate, dissent, representation, pluralism all provide us with best chance of coming to the best solutions for our problems, economic as well as political.

There isn't any single Platonic truth out there; but there is a reality that we might be able to approximate if we can work up an hypothesis, and the more information and intelligence we can bring to bear, the better. And at the epistemological level, it seems more likely that we'd arrive at something that conforms to external reality if we engage in a sort of society-wide Socratic dialogue than if the determination of truth is left to a small, authoritarian clique.

So when Gray dismisses free market economics as a parochial ideology because (citing Keynes) it can't be right about the future, he's allowing a failure to be perfect to discount an ability to be good. Free markets are worth employing because they're likely to be more right about what's going to work in creating economic surplus than any other system of organisation that we've come up with.

This approach undermines those policy makers and market operators who have a naive belief in the infallibility of the market (where are they all, by the way?). Instead, the market merely provides what is usually (not infallibly) the best view (not the correct view) of the future. There is therefore space for the state to intervene in the economy and, in doing so, it's not bound to be misguided and wrong. However, it's less likely to be right than the market and so should be extremely circumspect, even humble, in its interventions.

This approach poses fundamental questions about whether the rapid economic growth enjoyed by the centrally-directed Chinese economy can be expected to continue. The Chinese centre has been lucky in its predictions, against the odds, and it's going to need to stay lucky to maintain its success. I'm reminded of how the Soviets had the most advanced nineteenth century economy in the world fifty years too late, as this is what the planners thought modernity (full stop) looked like. It may have served them well in producing sufficient materiél to win the Second World War. But it didn't adapt, it didn't progress.

What mistakes is the Chinese centre making on the basis of similar misconceptions? The Chinese economy is superb if what you want is exports above everything. But after this? How will it adapt, how will it progress? Will the centre be able to repeat its predictive success? To use the journalist's most trite cop-out, only time will tell. And it might take quite a bit of time and trouble: the advanced nineteenth-century economy that the Soviets built in the twentieth, very nearly made it into the twenty-first.

Gray - whose books I find terrifically thought-provoking - commits the same mistake as the 'market fundamentalists': assuming that a set of practices, a collection of ways of doing things, makes up an ideology - in his case, he's then dismissive rather than evangelical. But markets are a tool, one that appears to arise naturally whenever people are in a position to exchange a surplus; when you find a lot of markets together they don't necessarily cohere into a system, they don't need to be encompassed by an ideology. In my view, it would be more useful to set about removing the ideological encrustations that encumber the way we organise ourselves today rather than dismiss the lot as a form of ideology that has no more purchase on reality than any other.

System-thinking, the construction, application and dismissal of models, can be highly misleading. This playing with Platonic forms obscures what works, what's useful, and in the instances discussed here, what's actually in front of our nose. It drenches our reality in ideology and as such encourages a bias to absolutist and procrustean thinking. John Gray is as prone to this as those ideologues he criticises.

H/t: Clive Davis.


Sean said...

Your best post in a long while Garth, there is a lot to say about all this.

I think what matters is "trends" now without going over old arguments, The demograpics matter for Europe because the economics matter, under normal circumstances demographics would not matter at all, but when you build a system of one generation supporting the next, when the numbers run out something has to give, in this case either a much smaller state or another surge of mass immigration to wipe our old bottoms. Now if something unexpected turns up, like a new unlimited cheap power source you can put that down to a black swan, against the trend, someone in years to come might read this and say I predicted it,(if it happened) which would be wrong I predicted nothing.

As too before the crash, I made plenty out of the consensus without really believing in it, I just went with the trend, which without spending months and months, (which would cost time which is money) of study is what most people do, they follow the trend until a better one turns up.

Would more info gained from an even more open society have helped, I doubt it. we tend to be over loaded these days with information to process.

Horizon was good last week, "why we talk" I am surprised you word geek fellas have not blogged, I did not know that the Bone geeks now believe that language came about because of he division of labour. The free market built into our brains, I thought as much.

Sean said...

btw, I think you will find China is well ahead on the trend front and is giving its people land rights (esp poor farmers), which will I am sure will help it in the next phase of its development.

Hey Skipper said...

[Gray] also points out that the success of China refutes those evangelising for the universal applicability and unique efficacy of the free market capitalist model. China's doing well without most of what the free marketeers deem essential for economic success, most importantly free markets.

I am astonished that Gray did not reach the conclusion staring him right in the face: China is doing well precisely because of free markets, the success of which is the sine qua non of China's statist export driven growth strategy.

It is also surpassing odd that one of the consequences of this strategy -- huge amounts of Chinese liquidity fueling asset bubbles -- apparently didn't warrant some mention.

What all this boils down to is that evolution beats intelligent design hands down.

Gaw said...

Sean: Thanks! Demographics may not be something that's going to help China. Over the next couple of decades the one child policy will give it a demographic structure similar to that of Japan today. But then there's still huge amounts of 'excess' labour in the countryside and in the old heavy industries.

Skipper: Indeed. It is most peculiar - there's a lot in his argument that seems to be highly questionable with readily available counter-arguments. A lot of the time, he seems to be knocking down a straw man which I'm not sure really exists in many places now. When he says there are 'many routes to growth', I'm not sure who he thinks disbelieves this. So what if late-Tsarist Russia grew rapidly? As you would rightly say this was in good part because of its exposure to markets. But it hardly turned out well did it?

As I say in the post I do find John Gray one of the most interesting thinkers around: his theories of being, knowledge, and his framing of history are very well conceived and described. But it's as if the categories he uses to enlighten in these areas get in the way when he looks at the nuts and bolts of markets and economic history more generally.