[lbo-talk] "Bedlamite economics" and the EMH

Ted Winslow egwinslow at rogers.com
Thu Nov 12 17:31:48 PST 2009


SA asked:


> Have you heard of something called behavioral economics?

Some time ago, I pointed on Pen-L to "behavioral economics" self- understanding of its relation to "mathematical finance".

While at least acknowledging the fact of irrationality in financial markets, it mistakenly identifies the ontological ideas that have dominated physics since the 17th century with “science” per se.

For the reasons set out by, among others, Keynes, these ideas are not applicable to the study of social phenomena in general and economic phenomena in particular. They ignore, for example, the fact and relevance of “internal relations”, a point also made by Marx and Engels.

The ontological, anthropological and psychological ideas that are appropriate to the study of these phenomena are essentially different from those that have dominated the study of physical phenomena since Newton. It’s these differences that constitute social “science” as a “moral science”.

“I also want to emphasise strongly the point about economics being a moral science. I mentioned before that it deals with introspection and with values. I might have added that it deals with motives, expectations, psychological uncertainties. One has to be constantly on guard against treating the material as constant and homogeneous. It is as though the fall of the apple to the ground depended on the apple's motives, on whether it is worth while falling to the ground, and whether the ground wanted the apple to fall, and on mistaken calculations on the part of the apple as to how far it was from the centre of the earth." (Keynes, Collected Writings, vol. XIV, p. 300)

Keynes also claimed that this mistake was unconsciously motivated and, for this reason, very difficult to correct through rational critique.

This is implicit in his psychobiographical essay on Newton, the main purpose of which was to dispute the idea of Newton as “the first and greatest of the modern age of scientists, a rationalist, one who taught us to think on lines of cold and untinctured reason.” (vol. X, p. 363) He substituted for this the idea that “in vulgar modern terms Newton was profoundly neurotic of a not unfamiliar type, but—I should say from the records—a most extreme example.” (p. 364)

It’s more explicit in his psychobiographical essays on economists, e.g. on Jevons and Edgeworth (the originators of “mathematical psychics”) where “the bright idea of reducing Economics to a mathematical application of the hedonistic calculus of Bentham” (vol. X, p. 184) is treated as a symptom of obsessional psychopathology.

It's for this reason, he claims, that the kind of mind dominant in physics since Newton, the "quant" mind of the "remorseless logician", lacks the capabilities required for insight in the "moral sciences".

"Professor Planck, of Berlin, the famous originator of the Quantum Theory, once remarked to me that in early life he had thought of studying economics, but had found it too difficult! Professor Planck could easily master the whole corpus of mathematical economics in a few days. He did not mean that! But the amalgam of logic and intuition and the wide knowledge of the facts, most of which are not precise, which is required for economic interpretation in its highest form is, quite truly, overwhelmingly difficult for those whose gift mainly consists in the power to imagine and pursue to their furthest points the implications and prior conditions of comparatively simple facts which are known with a high degree of precision." (Collected Writings, vol. X, p. 186)

Keynes makes the same claim about the representation of “rationality”in financial markets as “mathematical finance”. This, he claimed, was not merely not “rational”; it was “irrational”, i.e. an unconsciously anchored means of denying the “uncertainty” of the long fun, the long run in which it is certain “we are all dead.”

"it was, I think, an ingredient in the complacency of the nineteenth century that, in their philosophical reflections on human behaviour, they accepted an extraordinary contraption of the Benthamite School, by which all possible consequences of alternative courses of action were supposed to have attached to them, first a number expressing their comparative advantage, and secondly another number expressing the probability of their following from the course of action in question; so that multiplying together the numbers attached to all the possible consequences of a given action and adding the results, we could discover what to do. In this way a mythical system of probable knowledge was employed to reduce the future to the same calculable status as the present. No one has ever acted on this theory. But even today I believe that our thought is sometimes influenced by some such pseudo-rationalistic notions." (vol. XIV, p. 124)

“I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future." (vol. XIV, p. 115)

In contrast and like MacKenzie and Millo, Robert Shiller, in The Subprime Solution, treats “mathematical finance theory” as a correct representation of “rationality” in financial markets. “Behavioral” finance and “financial engineering” based on it are then presented as taking account of departures from this “rationality” in a way analogous to “adding “a theory of friction” to “Newtonian mechanics”.

“Denying the importance of psychology and other social sciences for financial theory would be analogous to physicists denying the importance of friction in the application of Newtonian mechanics. If one is permitted to apply Newtonian mechanics only in realms where friction can be completely disregarded, then one is confining its application largely to astronomy. Once we add a theory of friction, Newtonian mechanics can begin to be applied to earthly problems as well, and it becomes an essential tool for engineers who are designing devices to improve our daily lives. We have a comparable opportunity today with the advent of behavioral economics, which has the potential to facilitate exciting advances in financial engineering.”


> the subprime crisis has revealed a poverty of imagination on the
> part of leaders in initiating the reforms needed to build the new
> institutional foundations for a more secure economic environment.
> This chapter suggests ways of beginning just such an institutional
> reform initiative.
>
> It’s the Technology
>
> Institutional reform starts with understanding the available
> technology. Information technology is the story of our time. It is
> key to the subprime solution. Th e continued growth of computers,
> data collection and processing capabilities, “smart” technology, and
> rapid, inexpensive communications all provide dramatically eff
> ective tools to implement the subprime solution—to correct some of
> the egregious faults in the economy’s institutional foundation.
> Along with this expanding information technology, there
> has been over recent decades a magnificent development of our
> knowledge in the field of mathematical finance. The field has
> captured the imaginations of mathematically inclined people, from
> traditional economics departments, to mathematics departments, to
> management schools, and now to engineering schools with their new
> financial engineering programs, and to numerous quant groups at
> investment banks and hedge funds. This
> theory, as part of economics, in turn allows us to harness the full
> potential of risk-management technology—especially when it is
> implemented on a sufficiently large scale, as our information
> technology now allows. Th e theoretical advances are important, for
> they tell us where and how to look for opportunities to use
> financial technology to advance human welfare.
> Mathematical finance theory helps us understand how both
> sides of a financial contract can benefi t from the contract, and it
> suggests how we can optimize the participation of the two sides so
> that human welfare as a whole is enhanced. We must rely on such
> theory if we are to avoid inconsistent and erratic policy proposals
> to deal with crises, such as capriciously awarding bailouts to some
> without properly considering the context, the appropriate
> incentives, or who is on “the other side,” paying for the bailouts.
> Modern financial theory has as an important component in
> agency theory. Agency theory explains how to motivate agents to
> behave as much as possible in the interests of all parties to a
> transaction, not just themselves. It is a theory that explains how
> to keep moral hazard under control by structuring financial
> institutions with just the right balance of incentives.
> In a similar vein, the human sciences—psychology,
> sociology, anthropology, and neurobiology—are increasing our
> understanding of the mind by leaps and bounds, and this knowledge is
> now being applied to finance and economics. We have a much better
> grasp of how and why people make economic errors, and of how we can
> restructure institutions to help avoid these errors.
> There has been an important revolution with the
> development, in the past few decades, of the field of behavioral
> economics, including behavioral finance. This
> discipline incorporates insights gained in other social sciences.
> For that reason, many financial theorists of the old school have
> resisted this revolution, for they fear that it renders their
> mathematical models useless. On the contrary —it opens up their
> models to far richer and more successful applications.
> Denying the importance of psychology and other social
> sciences for financial theory would be analogous to physicists
> denying the importance of friction in the
> application of Newtonian mechanics. If one is permitted to apply
> Newtonian mechanics only in realms where friction can be completely
> disregarded, then one is con
> fining its application largely to astronomy. Once we add a theory of
> friction, Newtonian mechanics can begin to be applied to earthly
> problems as well, and it becomes an
> essential tool for engineers who are designing devices to improve
> our daily lives. We have a comparable opportunity today with the
> advent of behavioral economics, which has the potential to
> facilitate exciting advances in financial engineering.
> New institutions can be developed to solve many of the
> world’s fundamental risk problems. But, as noted previously, this
> can be achieved only if the institutional foundations are
> retrofitted to produce greater economic growth through steadily
> expanded asset ownership—especially homeownership.
> (The Subprime Solution, pp. 116-20 <http://www.npr.org/templates/story/story.php?storyId=96960228
> >)

Shiller and Akerlof recently published a book, Animal Spirits, that takes its title from Keynes yet ignores Keynes's argument that both this misidentification of "science" with physics and of a "science" of financial markets with "mathematical finance" are themselves symptoms of obsessional psychopathology, a psychopathology that, like the psychopathology he took to be dominant in financial markets themselves, Keynes understood in terms of psychoanalytic rather than behavioral psychology.

Ted



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