It’s greed and fear
by Michael Roberts
Larry Summers is one of the world’s leading Keynesian economists,
a former Treasury Secretary under President Clinton, a candidate
previously for the Chair of the US Fed, and a regular speaker at the
massive ASSA annual conference of the American Economics Association,
where he promotes the old neo-Keynesian view that the global economy
tends to a form of ‘secular stagnation’.
Summers has in the past attacked (correctly in my view)
the decline of Keynesian economics into just doing sterile Dynamic
Stochastic General Equilibrium models (DSGE), where it is assumed that
the economy is stable and growing, but then is subject to some ‘shock’
like a change in consumer or investor behaviour. The model then
supposedly tells us any changes in outcomes. Summers particularly
objects to the demand by neoclassical and other Keynesian economists
that any DSGE model must start from ‘microeconomic foundations’ ie the
initial assumptions must be logical, according to marginalist
neoclassical supply and demand theory, and the individual agents must
act ‘rationally’ according to those ‘foundations’.
As Summers puts it: “the principle of building macroeconomics on
microeconomic foundations, as applied by economists, contributed next to
nothing to predicting, explaining or resolving the Great Recession.” Instead, says Summers, we should think in terms of “broad aggregates”,
ie empirical evidence of what is happening in the economy, not what the
logic of neoclassical economic theory might claim ought to happen.
Not all Keynesians agree with Summers on this. Simon Wren-Lewis, the
leading British Keynesian economist claims that the best DSGE models
did try to incorporate money and imperfections in an economy: “respected macroeconomists (would) argue that because of these problematic microfoundations, it is best to ignore something like sticky prices (wages) (a key Keynesian argument for an economy stuck in a recession – MR)
when doing policy work: an argument that would be laughed out of court
in any other science. In no other discipline could you have a debate about
whether it was better to model what you can microfound rather than
model what you can see. Other economists understand this, but many
macroeconomists still think this is all quite normal.” In other
words, you cannot just do empirical work without some theory or model to
analyse it; or in Marxist terms, you need the connection between the
concrete and the abstract.
There is confusion here in mainstream economics – one side want to
condemn ‘models’ for being unrealistic and not recognising the power of
the aggregate. The other side condemns statistics without a theory of
behaviour or laws of motion.
Summers
reckons that the reason mainstream economics failed to predict the
Great Recession is that it does not want to recognise ‘irrationality’ on
the part of consumers and investors. You see, crises are probably
the result of ‘irrational’ or bad decisions arising from herd-like
behaviour. Markets are first gripped by ‘greed’ and then suddenly
‘animal spirits’ disappear and markets are engulfed by ‘fear’. This is a
psychological explanation of crises.
Summers recommends a new book by behavioural economists Andrei Shleifer’s and Nicola Gennaioli, “A Crisis of Beliefs: Investor Psychology and Financial Fragility.” Summers proclaims that “the
book puts expectations at the center of thinking about economic
fluctuations and financial crises — but these expectations are not
rational. In fact, as all the evidence suggests, they are subject to
systematic errors of extrapolation. The book suggests that these errors
in expectations are best understood as arising out of cognitive biases
to which humans are prone.” Using the latest research in psychology
and behavioural economics, they present a new theory of belief
formation. So it’s all down to irrational behaviour, not even a sudden
‘lack of demand’ (the usual Keynesian reason) or banking excesses. The
‘shocks’ to the general equilibrium models are to be found in wrong
decisions, greed and fear by investors.
Behavioural economics always seems to me ‘desperate macroeconomics’.
We don’t know why slumps occur in production, investment and employment
at regular and recurring intervals. We don’t have a convincing
theoretical model that can be tested with empirical evidence; just
saying slumps occur because there is a ‘lack of demand’ sounds
inadequate. So let’s turn to psychology to save economics.
Actually, the great behavourial economists that Summers refers to
also have no idea what causes crises. Robert Thaler reckons that stock
market prices are so volatile that there is no rational explanation of
their movements. Thaler argues that there are ‘bubbles’, which he
considers are ‘irrational’ movements in prices not related to
fundamentals like profits or interest rates. Top neoclassical economist
Eugene Fama criticised Thaler. Fama argued that a ‘bubble’ in stock
market prices may merely express a change in view of investors about
prospective investment returns; it’s not ‘irrational’. On this point, Fama is right and Thaler is wrong.
The other behaviourist cited by Summers is Daniel Kahneman. He has
developed what he called ‘prospect theory’. Kahneman’s research has
shown that people do not behave as mainstream marginal utility theory
suggests. Instead Kahneman argues that there is “pervasive optimistic
bias” in individuals. They have irrational or unwarranted optimism.
This leads people to take on risky projects without considering the
ultimate costs – against rational choice assumed by mainstream theory.
Kahneman’s work certainly exposes the unrealistic assumptions of
marginal utility theory, the bedrock of mainstream economics. But it
offers as an alternative, a theory of chaos, that we can know nothing
and predict nothing. You see, the inherent flaw in a modern economy is
uncertainty and psychology. It’s not the drive for profit versus social
need, but the psychological perceptions of individuals. Thus the US
home price collapse and the global financial crash came about because
consumers have irrational swings from greed to fear. This leaves
mainstream (including Keynesian) economics in a psychological purgatory,
with no scientific analysis and predictive power.
Also, it leads to a
utopian view of how to fix crises. The answer is to change people’s
behaviour; in particular, big multinational companies and banks need to
have ‘social purpose’ and not be greedy!
Turning to psychology is not necessary for economics.
At the level
of aggregate, the macro, we can draw out the patterns of motion in
capitalism that can be tested and could deliver predictive power. For
example, Marx made the key observation that what drives stock market
prices is the difference between interest rates and the overall rate of
profit. What has kept stock market prices rising now has been the
very low level of long-term interest rates, deliberately engendered by
central banks like the Federal Reserve around the world.
Of course, every day, investors make ‘irrational’ decisions but, over
time and, in the aggregate, investor decisions to buy or to sell stocks
or bonds will be based on the return they have received (in interest or
dividends) and the prices of bonds and stocks will move accordingly.
And those returns ultimately depend on the difference between the
profitability of capital invested in the economy and the costs of
providing finance. The change in objective conditions will alter the
behaviour of ‘economic agents’.
Right now, interest rates are rising globally while profits are stagnating.
The scissor is closing between the return on capital and the cost of borrowing. When it closes, greed will turn into fear.
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