Right Reason

Hayek and Lucas on Economics

 

 

I wrote before about the paradigmatic differences between the approaches taken between the Austrians and New Classicals in how they approach economics. The differences go as deep as how the two paradigms even think about economics as a science.  

Certainly there is a heterogeneity to both paradigms to how they approach the scientific status of economics, Mises taking a harder line than Hayek for instance. Nevertheless, there are stark differences between the two. Those differences are revealed in the banquet speeches Hayek and Lucas each gave when receiving their Nobel Memorial Prizes in 1974 and 1995 respectively. 

 

In his banquet speech, Hayek was skeptical of whether the Prize, only five years old at the time, was a good thing. He argued that the institution of a Nobel Memorial Prize for economics would give economics too much prestige:

(T)he Nobel Prize confers on an individual an authority which in economics no man ought to possess.

This does not matter in the natural sciences. Here the influence exercised by an individual is chiefly an influence on his fellow experts; and they will soon cut him down to size if he exceeds his competence.

But the influence of the economist that mainly matters is an influence over laymen: politicians, journalists, civil servants and the public generally.

There is no reason why a man who has made a distinctive contribution to economic science should be omnicompetent on all problems of society - as the press tends to treat him till in the end he may himself be persuaded to believe.

Economists certainly have valuable things to contribute to the rest of society. Basic Econ 101, if fully understood, would greatly augment the general welfare. As Peter Boettke keeps saying, simple economics is not simple-minded economics. 

However, as economics moves beyond Econ 101, the ground that economists stand on does not adequately reflect their ambitions, and so one can get contradictory answers from Nobel-Memorial Prize Winners on basic questions as whether there is a trade off between inflation and unemployment.  The Swedish Riksbank surrounding practitioners of such a discipline with the mystique of a hard science, as a Nobel is bound to do, can lead to the creation of a dangerous class of technocrats whose advice, however flawed, is accepted by virtue of a Nobel’s prestige. 

 

The hope that a Nobel could serve as a focal point for the recognition of what it means to be a good economist was flawed because there were no feedback mechanisms for updating people’s esteem of different economists. In the physical sciences, those that babbled nonsense would quickly be revealed for the charlatans they are by the data, but economics does not have recourse to such mechanisms. It’s not that, as many continue to argue, that economics doesn’t care about data, it’s that even pinning down the concept of economic data is surprisingly difficult. Hayek commented on this predicament in his Prize lecture:

Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones. While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process, for reasons which I shall explain later, will hardly ever be fully known or measurable. And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated as important which happens to be accessible to measurement. This is sometimes carried to the point where it is demanded that our theories must be formulated in such terms that they refer only to measurable magnitudes.

 

Hayek’s skepticism about whether economics has a scientific character for which the Nobel Memorial could serve as a focal point is contrasted with Robert Lucas’ optimism. In Lucas’ banquet speech, he argued that the Nobel Memorial Prize was a valuable institution which served as a focal point for scientific exploration:

This prize was established in the 1960s, as a memorial, through the generosity of the Bank of Sweden. Generosity and, I would say, wisdom, as the establishment of a Nobel Prize in Economics has had a very beneficial effect on my profession, encouraging us to focus on basic questions and scientific method. It is as if by recognizing Economics as a science, the Bank of Sweden and the Nobel Foundation have helped us to become one, to come close to realizing our scientific potential.

Whereas Hayek is wary of the effects the Nobel Memorial Prize in Economic Sciences would have a positive effect on discourse, Lucas is optimistic. Lucas argued that the Prize heightened economists’ appreciation for basic principles, and the scientific character of their discipline. Prize Winners could serve as focal points for what it means to do good economics, and therefore advances economists’ notion of what it means to be a good economist. 

In Lucas’ view, the Nobel Memorial Prize serves well as a feedback mechanisms for the economics community to recognize good economics. Hayek is much more pessimistic, and feared the Prize would have too great an impact on the minds of those outside of economics proper.

 

The difference between the two, perhaps slight perhaps not, reveals that the two thought about economics differently. Hayek thought about it as a squishy, so to speak, discipline which did not have recourse to the same methods that the physical sciences had for ending disputes among its practitioners. Lucas thought, and continues to think of it, as a harder affair with the potential of such a  science. 

 

 

The Austrians and the New Classicals: One Strand of Thought?

 

 

 

"Normal science" means research firmly based upon one or more past scientific achievements, achievements that some particular scientific community acknowledges for a time as supplying the foundation for its further practice. 

-Thomas Kuhn, The Structure of Scientific Revolutions

 

Comparisons between the Austrians and the New Classicals are nothing new. The New Classicals often thought of themselves as continuing the Austrian project of theorizing by embracing equilibrium-theories of the business cycle inspired by Hayek’s work in the twenties. Alex Tabarrok wrote that has argued that Robert Lucas is the greatest Austrian economist of the 20^th century. The controversy now continues. 

In his blog, “Noahopinion”, Noah Smith argues that the New Classicals drank the Austrians' milkshake. They took what was worthwhile within the Austrian research program, and advanced it further than any Austrian has been able to. The problem with Smith’s argument is that even though there is much that the Austrians and New Classicals agree on, the disagreements between the two are far too many for the New Classicals and Austrians to be continued a single strand of thought. Those differences are brought to light when we consider that the New Classicals, who could very much be considered heirs to the techniques of the Market Socialist Oskar Lange, cannot make sense of the Austrian critique of socialism within their way of doing economics. 

  

The most major difference between the paradigm of Mises and Hayek, and that of Prescott and Lucas is not what they think about issues that Smith brings up like mathematics or disagreements about the nature of the business cycle. The most important differences, which informs the two paradigms’ very outlook is that that the two are contradictory in their answers to what economics is largely about. Whereas the Austrians focus on questions of how the order of the market order emerges, the New Classical assumes that order in their difference equations. 

The most succinct expression of the outlook of the Austrian school comes from Hayek in The Fatal Conceit when he wrote that “The most curious task of economics is to demonstrate to men just how little they really know about what they imagine they can design” (Hayek 1988, 76). On the other hand, in “Methods and Problems in Business Cycle Theory”, Lucas asserted: “One of the functions of theoretical economies is to provide fully articulated, artificial economic systems that can serve as laboratories in which policies that would be prohibitively expensive to experiment with in actual economies can be tested out at much lower cost.” Hayek’s vision of economics is to warn against the very intentions of Lucas: that no human being can have sufficient knowledge to design an economic order, it can only emerge from market process. There is an extreme tension here which betrays the radical difference between the two paradigms, and it is all made manifest by thinking about the Socialist Calculation Debate.

 

We must keep in mind that the Austrian economists' crowning achievement to this day is their proof of the impossibility of socialism during the Socialist Calculation Debate. Within that debate, Mises and Hayek argued that the socialist vision that an economic order could be created by the planning of one or many human minds was impossible, and that the only way for an economic order to come about was through the use of prices. Their legacy is in part built upon their work against socialist in the ‘20s, ‘30s, and 40’s. Anyone who wants to lay claim to improving upon the Mises-Hayek paradigm has to be able to capture the lessons of the Mises’ seminal article “Economic Calculation in the Socialist Commonwealth.” The New Classicals, with their emphasis on the important of analgoue economies. simply cannot do that. 

Even though Lucas emphasizes that we must be mindful of the difference between real and toy economies, the notion that economists could even sufficiently approximate the nature of the economy  in theory would be absurd to both Mises and Hayek. Neither Austrian would have anything to do with statements like:

On this general view of the nature of economic theory then, a ‘theory’ is not a collection of assertions about the behavior of the actual economy but rather an explicit set of instructions for building a parallel or analogue system - a mechanical imitation economy. A ‘good’ model from, this point of view, will not exactly be more ‘real’ than a poor one, but will provide better imitations (Lucas, 1980).

If Mises and Hayek were to read that quote, I bet they would be reminded of Oskar Lange’s argument that socialism could work because the central planning board could serve the function of the Walrasian auctioneer, and direct the use of factors of production with knowledge of their marginal costs. The Austrians disagreed, and Mises shot the first shot in 1920 with “Economic Calculation in the Socialist Commonwealth.” 

 

They argued that Lange greatly overestimated the potential of the human mind to comprehend the economic order, so does Lucas, and that overestimation separates his work work from the tradition of the Austrians because the Austrian tradition constantly emphasized that the market order was simply too complex to be adequately summed up in a system of stochastically disturbed difference equations.     

So much of Austrian scholarship has been inspired by the problems of the emergence of a social order from decentralized cooperation which the Lucas-Prescott paradigm cannot capture. The Mises-Hayek paradigm is concerned first and foremost with the study of spontaneous order, and with the the emergent properties caused by the connectedness between market participants. (Arnold Kling, in his own response to Noah Smith got at the importance of the issue of connectedness when he wrote:  The bottom line: Austrian economics ought to resemble PSST, not New Classical.) The New Classical toy economy cannot capture those aspects of the market order, and so role of spontaneous order in the hat the Austrian School has to do with complexity, and the interconnectedness of human beings within society is manifest in Human Action when Ludwig von Mises wrote:

The (socialist) director does not simply have to deal with coal as such, but with thousands and thousands of pits already in operation in various places, and with the possibilities for digging new pits, with the various methods of mining in each of them, with the different qualities of coal in various deposits, with the various methods for utilizing the coal for the production of power, and a great number of derivatives (Mises 1998, 695).

The New Classical paradigm cannot even sense of problems of connectedness because of their adherence to general equilibrium as the way of doing economics. 

 

The very nature of how general-equilibrium theory is constructed glosses over the facts that there are particular paths of interaction within a market order. Jason Potts, a fellow heterodox to the Austrians, addressed this concern in The New Evolutionary Microeconomics:

The quality of space being integral derives from the assumption that a single (mathematical) operation links any point in economic space with any other point. Interactions, knowledge, and structure specific connections between points in space and therefore the very existence of these concepts is excluded by the assumption that all points relate, a priori, to all other points directly; that is, with a single mathematical operation (Potts 2000, 17).

Robert Lucas had profuse praise for Gerard Debreu’s Theory of Value, a work which sought to prove that a Pareto optimal distribution of a set resources could be created consistent with profit and utility maximization? On the back of the book Lucas praises The Thgeory of Value as an “immortal classic in twentieth-century economics.” The central role which the New Classicals think that such equilibrium frameworks, especially competitive equilibrium, played in the normal science of economics is a major point of divergence between them and the Austrians. 

 

Competitive equilibrium assumes away the questions of conceitedness which the Austrians are most concerned with, and have given rise to Kirzner’s writings about the entrepreneur, and even Hayek’s ideas about the business cycle. If we are to think about an intellectual’s theorizing as a means of him satisfying the uneasiness certain problems weigh on his mind, we could say that competitive equilibrium assumes away the problems which the Austrians are most troubled by. Mises, for instance, critiqued the use of mathematics in economics for looking over all the questions which should make economists wonder about the possibility of a socialist economy:  

The result is that from the writings of the mathematical economists the imaginary construction of a socialist commonwealth emerges as a realizable system of cooperation under the division of labor, as a fully-fledged alternative to the economic system based on private control of the means of production. The director of the socialist community will be in a position to allocate the various factors of production in a rational way, i.e., on the grounds of calculation (Mises 1998, 698).

For Mises, competitive-equilibrium frameworks glossed over the problems of coordination and price emergence which doomed the hopes of would-be socialists, and as a result that framework did not capture enough of the economy’s essence to be that useful to the study of that phenomenon.  

Lucas’ assertion that economics could create toy economies sufficiently realistic to provide a preliminary testing ground for regulations is of the type which Mises is arguing against here. Even though Prescott, Lucas, and other New Classicals would have recourse to other arguments for why a socialist director would not be able to construct an economic order from on high, they cannot make sense of Mises’ and Hayek’s theses about how cooperation conditioned by prices are able to conquer, to quote Keynes, the dark forces of time and ignorance everyone faces in economic life. As a result, the New Classicals could even be considered a decay, rather than a refinement, of the Austrian insights into the nature of the market order, and of society at large.

 

In the end, there is not a lot of room for the Austrian insights about human competition within a model of an analogue. By asserting that the New Classicals have adopted and advanced the Austrian research program, Noah Smith has  Two features really make the paradigm of Mises and Hayek special: that the two look at purposeful action within the context of radical uncertainty, and the interconnectedness between human beings which results from such behavior. Whereas Prescott and Lucas theorize about a world of linearity and smoothness, Mises and Hayek theorized about a world of complexity and uncertainty. 

So no, the Austrians and New Classicals are not one strand of through. Rather than the New Classicals drinking the Austrians milkshake, stealing their ideas while giving them no credit (in the comments: Noah Smith notes: “I would say someone else picked up a lot of their ideas, ran with them, and won, but didn't give the Austrians any credit... ;-)”), the New Classicals represent the fruition of the economic approach of the Market Socialists. Indeed, it wouldn’t be an understatement to say that Ludwig von Mises and Friedrich Hayek share more in common with John Maynard Keynes and Hyman Minsky than they do either Prescott or Lucas. 

 

 

 

Bibliography  

Debreu, Gerard. Theory of Value. Newhaven and London: Yale University Press, 1987.

Hayek, Friedrich von. The Fatal Conceit. Chicago: Chicago University Press, 1988.

Lucas, Robert. “Methods and Problems in Business Cycle Theory.” Journal of Money, Credit, and Banking 12.4 (1980): 696-715.

Mises, Ludwig von. Human Action. Auburn: Ludwig von Mises, 1998.

Potts, Jason. The New Evolutionary Microeconomics. Northhampton, Edward Elgar Publishing, Inc., 2000. 

Brownian Motion and the Possibility of Psychohistory

 

Brownian motion in three dimensions. 

 

This post is inspired by a conversation that I had with Professor Anthony Davies at the Mercatus Center two days ago.

The phenomenon known as Brownian motion was first noticed by the biologist Robert Brown when peering through the lens of a microscope he noticed pollen grains moving in water and yet was unable to provide an explanation for what caused that movement. Eventually Albert Einstein and Marian Smoluchowski provided an explanation in terms of the movement of particles suspended in a gas or liquid that are completely random. As a result, we can only know about the movement of particles with the use of probability distributions and no deterministic (i.e. one-to-one causality) model can be created to explain them.

A consequence of this is that there cannot be a deterministic theory about the motion of particles at within a liquid or a gas at a very small scale. The purely random and unpredictable Brownian motion thus prevent the creation of any model that can predict the movement of particles within a small population of molecules in which the noise of Brownian motion has yet to be drowned out. Thus it is not until that there is a much larger population of molecules, in terms of billions, that theorists can actually create models that create testable predictions.

Turning to contemporary economics, as Arnold Kling argues throughout his “Million Mutinies”  eries at The America, part three (the most pertient to the point here) is linked to, the entire scientific project of macroeconomics over the past century has failed. The notion that, to borrow Robert Lucas' phrasing, economics can create an analogue economy through systems of equations and then compare that model's results to the real world with any scientific basis has proven a failure. For one thing, these models, which stand on very precarious ground, even after plenty of calibrations have always been torn asunder by random events that the designers did not see coming. They have never proven capable of making sense of the random and unforeseen black-swans events that have come to shape human history. Nor will they ever be able to. The mathematical methods that are used in order to build models just cannot deal with unforeseen events leading many economists, especially New Classicals in the 70s and 80s, to reject that economics even applies to scenarios of Knightian uncertainty.

However, taking inspiration from the phenomenon of Brownian motion, perhaps it is the case that the only problem with the modern project of modern macroeconomics is that it tries to create models for a population that is simply too small for the noise to diminish to such a degree that deterministic modeling, modeling that can actually produce a reliable prediction. Perhaps if there is only a large enough human population then the super-accurate modeling as seen in Isaac Asimov's Foundation series would be possible. Perhaps if only the population of all humans were numbered in googles rather than trillions all of the idiosyncrasies of human events are evened out just as when the population of molecules become large enough, Brownian motion is canceled out. High hopes, but the only hope for a would-be psychohistorian.

That being said, I still have strong doubts that I'll get to in another post.

Economics: What it Can and Cannot Do

From The National Review:

After 40,000 years of civilization, we very clever creatures still cannot predict the weather with any reliable degree of detailed accuracy more than about a week out. (But some of us still pray for rain.) Scientists who have spent their lifetimes working on extraordinarily specialized problems routinely are baffled by new and unexpected developments. (But some of us still believe the universe is turtles all the way down.) Our highest-paid stock-pickers routinely are outperformed by darts thrown at a board, by kindergartners, and by monkeys. (But some of us still believe in the sure thing.) On and on it goes: Executives reliably make disastrously bad decisions about their own businesses, and most entrepreneurs fail.

In spite of the massive piles of evidence surrounding them, politicians routinely tell us that if we will merely give them the power to do X, then Y surely will follow. The Obama administration predicted that if the stimulus and other policies were enacted, then unemployment would decline to 5.2 percent. (It isn’t 5.2 percent.) Mitt Romney says that if we enact his agenda, the result will be 4 percent growth. Personally, I think that politicians should be goosed with a Taser every time they use the word “percent” in a future-tense sentence. But to be more charitable, let’s instead conclude that such projections should be viewed skeptically.

Unhappily, many economists desire to play kingmaker and therefore lend the prestige of their discipline to the wishful thinking of politics, where arguments are oversimplified to a point that is indistinguishable from dishonesty. They are aided in this by journalists who provide a bridge from the rigorous world of academic research to the standards-free world of political discourse. The result is something like a fairy tale or just-so story. That voters choose to accept such fanciful promises is another piece of evidence that our politics is not rational but ritual.

 

Closely related to this is Friedrich Hayek's now famous quote from The Fatal Conceit: "The curious task of economics is to demonstrate to men how little they really know about what they can imagine they can design." Also related is Hayek's banquet speech after recieving the Nobel Memorial Prize:

(T)he Nobel Prize confers on an individual an authority which in economics no man ought to possess.

This does not matter in the natural sciences. Here the influence exercised by an individual is chiefly an influence on his fellow experts; and they will soon cut him down to size if he exceeds his competence.

But the influence of the economist that mainly matters is an influence over laymen: politicians, journalists, civil servants and the public generally.

There is no reason why a man who has made a distinctive contribution to economic science should be omnicompetent on all problems of society - as the press tends to treat him till in the end he may himself be persuaded to believe.

One is even made to feel it a public duty to pronounce on problems to which one may not have devoted special attention.

I am not sure that it is desirable to strengthen the influence of a few individual economists by such a ceremonial and eye-catching recognition of achievements, perhaps of the distant past.

I am therefore almost inclined to suggest that you require from your laureates an oath of humility, a sort of hippocratic oath, never to exceed in public pronouncements the limits of their competence.

Economics is not a discipline dealing with exact predictions about future events. Even the idea that we can know how the economy will function in the coming years can pretty much be falsified in one image:

 

The most humbling image for modern economics.

Blaming the failure of that prediction on merely the partisan desires of the Council of Economic Advisers is missing the point. There were good economists that sat on the council and Christina Romer, certainly a successful economist by any objective criteria, chaired it. However, the economics profession as a whole has been infected by the idea that the type of precision found in the physical sciences can and ought to be striven for in economics.

Robert Lucas advocates this type of approach in his article, "Methods and Problems in Business Cycle Theory", when he writes:

One of the funcations of theoretical economics is to provide fully articulated, artificial economic systems that can serve as laboratories in which policies that would be prohibitively expensive to experiment with in actual economies can be tested out at much lower cost. To serve this function well, it is essential that the articial "model" economy be distinguisged as sharply as possible in discussion from actual economies.

and

On this general view of the nature of economic theory then, a "theory" is not a collection of assertions about the behavior of the actual economy but an explicit set of instructions for builing a parallel or analogue system - a mechanical, imitation economy. A "good" model, from this point of view, will not be exactly more "real" than a poor one, but will provide better imitations. Of course, what one means by a "better imitation" will depend on the particular questions to which one wishes answers.

This is pseudo-scientific nonsense. The economy is simply too complex for a single model to be able to imitate and by focusing on testing singular propositions with these models, Lucas looses focus on what economics can do.

Economics can never say whether or not GDP will increase by a given percent each year. It can never provide us with a reliable prediction of the course of unemployment in the course of even a couple of years. What economics can do, though, is provide pattern predictions about the general pattern of the economy at the margins.

It can tell us that instituting rent-control will lead to a shortage of low-income housing at the margin and it can inform us that at the margin landlords will seek other means, like a key charge, for charging for rent. It can tell us that expanding the money supply beyond the demand for it will lead to inflation. It can tell us that socialism will anywhere and everywhere fail. Those are powerful predictions, but they do not try and overstep the bounds of economic reasoning by making predictions about the exact quantities that will change or the exact times those changes will happen.

Such predictions are now and will always be beyond the economist.