Goodbye rational expectations

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Roman Frydman and Michael D. Goldberg, the authors of "Imperfect Knowledge Economics: Exchange Rates and Risk," have a well-argued piece in the Times that amounts to a full-frontal attack on the Rational Expectations Hypothesis (REH) that underlies much of mathematical economics. Their claim is that flawed theories of market 'efficiency' and 'rationality' have led economics and policy astray with recent disastrous results.

Although 'rationality' in common parlance is a synonym for 'reasonableness,' many economists take a rational individual to be "someone who behaves in accordance with a mathematical model of individual decision-making that economists have agreed to call rational."

The centrepiece of this standard of rationality, the so-called Rational Expectations Hypothesis (REH), presumes that economists can model exactly how rational individuals comprehend the future.

In effect, REH-based models make markets unnecessary because they use equations rather than adaptive learning to predict outcomes. Yet Hayek has shown how markets can contain in dispersed form more information than is accessible to anyone, and Popper has illustrated the impossibility of predicting future knowledge. REH models gloss over these objections as they use their assumptions to 'price' new derivative products and 'predict' outcomes.

Real markets are uncertain. It is not that people are irrational, just that their rationality does not lend itself to mathematical modelling.

Thus, the behavioral view suggests that swings in asset prices serve no useful social function. If the State could somehow eliminate them through massive intervention, or ban irrational players by imposing strong regulatory measures, the “rational" players could reassert their control and markets would return to their normal state of setting prices at their true values.

In fact, say Frydman and Goldberg, asset prices are subject to swings because "participants must cope with ever-imperfect knowledge about the fundamentals that drive prices in the first place."

One of the few good things to come out of the financial crisis is a re-examination of the fundamentals of Austrian Economics. One of them is that value is entirely subjective, residing in the mind of the individual, not in the object contemplated, and that it changes over time and is different between individuals. This is light years away from the REH-based models that have dominated academic economics, and treated it as practically a subset of mathematics. For some years now most academic economists have talked only to each other, describing in ever more detail a fantasy world that never touches reality. If the crisis undermines the heresy of Rational Expectations, at least some good will have come from it.

Dr Madsen Pirie has recently published "101 Great Philosophers."

The powers of the EU superstate

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What exactly are the powers of the European Union, whose Lisbon Treaty has now been fully ratified and will come into force in December? What policy areas is Brussels responsible for, and which are reserved to the Member States?

This is an important question for the UK and its next government, which claims it will repatriate certain powers to Westminster. And yet it is not altogether easy to find the answer.

The reason is that the powers of the EU have expanded far beyond those which most people – viewing the EU as primarily a trade bloc, which also co-ordinates its members’ actions on some necessarily international issues – would expect it to have.

Indeed, if you look at the original Constitutional Treaty (really just the Lisbon Treaty presented in slightly less tortuous and impenetrable language), you will see that the real scope of the EU’s powers is really quite extraordinary.

Brussels has ‘exclusive competence’ on five issues: the customs union, competition rules, monetary policy in the eurozone, conservation of marine biological resources, and commercial policy. Only the EU may legislate in these areas.

Then there are ‘shared competences’, where member states can act, but only if the EU has chosen not to. These include: the internal market, social policy, economic social and territorial cohesion, agriculture and fisheries, the environment, consumer protection, transport, energy, health and safety, and the ‘area of freedom, security and justice’. International aid, research and development and ‘space’ are also shared competences, but in these cases EU action does not exclude member state action.

There are also areas where the EU has competence to carry out ‘supporting, co-ordinating or complementary action’: the protection and improvement of human health, industry, culture, tourism, education, sport, vocational training, civil protection, etc.

Finally, the EU is also meant to make ‘arrangements’ for the co-ordination of member states’ economic and employment policies, and to carry out ‘initiatives’ to ensure the co-ordination of social policies. It is also meant to define and implement a common foreign and security policy, including the ‘progressive framing’ of a common defense policy.

To put it another way: almost nothing is reserved for member states, and the EU may take action in more or less wherever and whenever it pleases. And I'm pretty sure that's not what we signed up for...

It's new business, not business, which is important

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We see various politicians running around and firehosing our money at extant businesses as a way of stopping the recession and there are those who praise such actions. They are those, of course, who have not really quite grapsed what a recession is. It isn't a time when 100% of the people lose 10% of their income: it's when 10% lose 100%. And it isn't particularly a time when more people lose their jobs than normal. It's when fewer of those who do fail to find new ones. For the gales of creative destruction are always roaring through the economy: it's the creating of new businesses and thus new jobs which fails at these times.

According to the Census Bureau, nearly all net job creation in the U.S. since 1980 occurred in firms less than five years old. A Kauffman Foundation report released yesterday shows that as recently as 2007, two-thirds of the jobs created were in such firms. Put more starkly, without new businesses, job creation in the American economy would have been negative for many years.

The US economy is little different from the UK in this regard. The importance of this is that a rising unemployment rate (which is of course simply the balance between those jobs lost and new created rather than an absolute measure of either) is not particularly caused by firms dying, thus our solution is to prop such up. That is always happening and does not always lead to a rising unemployment rate. It is the lack of new companies and organisation providing those new jobs which leads to the rising unemployment rate. Thus, in order to lower it, we should turn our attention not to the old and large companies, but to the small and new.

And there is a simple, no cost, solution to the problems of the small and new. No, not subsidised loans, not government provided capital, rather, an absence of government in crucial parts of the system. The absence of the dead hand of the bureaucracy that stifles their creation. The thousands upon thousands of regulations and laws that state that you may do this, you must fill out that form, you may not do that, do not proceed without authorisation.

Get rid of that and we'll have more small firms created, more expanding, and thus a lower rate of unemployment. All at no cost: you see, sometimes, there really are free lunches.

Pro-business or pro-market?

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In the journal of the American Enterprise Institute, James DeLong reviews the National Affairs article "Capitalism After the Crisis" by Prof Luigi Zingales of the University of Chicago. Zingales makes the important disctinction between being pro-market and pro-business. DeLong echoes Zingales, noting that:

Business, especially big business, is happy with crony capitalism, franchised monopoly, or any other device that will avoid the Darwinism of the free market. Of the billions of dollars now spent lobbying, almost none supports the free market as a concept or an institution.

Big businesses spend money lobbying for special advantage. They do not seek a level playing field, but laws and regulations which benefit their own circumstances at the expense of fair competition. Their aim is to use the law to make money, and legislators seem all too ready to comply with their objectives. Toymakers Hasbro and Mattel both lobbied for the Consumer Product Safety Improvement Act, and "even as the law has brought undreamt-of woe to thousands of smaller producers of kids’ products, the two big companies seem to be doing rather well out of it."

Although opponents of capitalism often treat pro-market and pro-business as the same thing, the reality is that it is regulation and government power which offer business a free lunch, while the market makes them work for it. Businessmen oppose monopoly when they are buying, but tend to favour it when they are selling.

Zingales suggests we should "put rules in place that keep large financial firms from manipulating government connections to the detriment of markets." The same could be done for other sectors of the economy. He says that:

The alternative path is to soothe the popular rage with measures like limits on executive bonuses while shoring up the position of the largest financial players, making them dependent on government and making the larger economy dependent on them. Such measures play to the crowd in the moment, but threaten the financial system and the public standing of American capitalism in the long run.

Unfortunately Zingales thinks that the Obama administration has chosen the latter path. And the 1,990 detailed pages of the Health Care Bill provide yet more ammunition for that view.

Dr Madsen Pirie is author of the recently-published "101 Great Philosophers."

A proposal for solving the pension crisis

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We need to wean people off the state pension. It’s a giant Ponzi scheme that sooner or later will become bankrupt. But we cannot simply scrap it. Too many people have based their future plans on its existence, and it is too late for them to make up for its removal.

In a new Think Piece I have drafted for the ASI, I propose phasing it out in such a way that those over 60 get a full pension, anybody under 20 gets no pension, and the rest of us see our pensions tapered away at a rate relative to the amount of time we have to make alternative arrangements. Mechanisms would be put in place to ensure that the poorest were not left without any support, and that nobody was blindsided by a sudden market collapse. But basically the onus would be on each of us to prepare for our own future.

This is an idea I have been turning over in my head for some time. It seems reasonable to me, and I’ve tried to address the objections that I envisage. But it’s far from a detailed plan, and I would welcome comments from others who may be able to see problems, improvements or opportunities.

Please read the full article here and then feel free to comment below.

Up the proverbial creek...

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Britain's current-year deficit of 12.4 per cent of GDP will not automatically fall to 0. The Treasury's latest scenario foresees a gradual reduction to 5.5 per cent in 2013-14, raising the ratio of debt to GDP to 76 per cent, only a little above the Western European average. It is not made explicit how the deficit reduction is to be achieved—spending cuts are no doubt tacitly assumed—except that the growth rate of the economy is supposed to rise spectacularly to 3.25 per cent from 2011 onwards. If the average interest rate on the debt were to settle at 5 per cent, the interest cost on the projected 76 per cent of GDP would be 3.8 per cent of GDP a percentage point more than at present. To accommodate this and still achieve a reduction of the deficit to 5.5 per cent, non-interest spending would have to be squeezed by 7.9 per cent of GDP. Anyone who believes that this will be done has never understood democracy.

Anthony de Jasay, 'Who Is Afraid of the National Debt?', The Library of Economics and Liberty.

A proposal for solving the pension crisis

ASI Fellow and Associate Director of CentreForum Tom Papworth sets out how to solve the looming pensions crisis.

We need to wean people off the state pension. It’s a giant Ponzi scheme that sooner or later will become bankrupt. There used to be five working age people supporting each pension; now there are two, and in the future that number will shrink. It cannot go on.

However, we can’t just scrap it. Too many people have based their future plans on its existence, and it is too late for them to make up for its removal. To tell a 50 year old that they won’t get a state pension is unfair: they’ve worked for thirty years expecting it, and not prepared for a world without it. But I see no reason why we should not tell a 20 year old that they won’t get a state pension, as they have all the time in the world to make their own arrangements.

I have been considering a phasing out approach. Anybody over 60 gets a full pension; anybody under 20 gets no pension. The rest of us see our pensions tapered away at a rate that equals 2.5 percent per year off retirement. Thus, the 50 year old would get almost two thirds of a full state pension, and would have 15 years to make their own arrangements to supplement that amount. I would get slightly less than one third of a state pension, but would have three decades to prepare for a world where my state pension was meagre.

There are two problems with this approach, as I see it. The first is that young people would have to pay in to a system from which they did not benefit. This would generate some understandable resentment. However, we cannot refuse to implement changes on the grounds that certain groups will in the future not benefit where those in the same group but in a previous generation did benefit. That argument, often deployed by students to oppose tuition fees (“You all got a free higher education, so it is unfair to deny it to us”), is the quintessence of Conservativism: a fundamental opposition to change. That same argument, 100 years ago, would have cut the other way: old people benefited from a system into which they had not paid; one generation was being taxed where the previous generation was not. That did not prevent the state pension being created and nor should it have.

I would suggest that we could counter the objection among younger workers in three ways:

  • Firstly, by pointing out that the current system is a lie and that one way or another the state pension is ultimately bankrupt. It is better to taper it out than to reach a crisis point for which nobody has prepared.
  • Secondly, by pointing out that they are in many cases paying for their own parents, just as their parents paid things that they benefited from (such as free childcare) which their parents never enjoyed.
  • Thirdly, and this is perhaps the best bit, by pointing out that over time taxes will be able to fall, so that as they get older the tax burden will be reduced, meaning that they can finance their (probably superior) private pension out of the difference, and probably still be better off than their overtaxed parents.

The other objection that I envisage is that the state pension provides for people regardless of wealth, and that the poorest are not able to afford a private pension. While I doubt that this is as true as those who make that argument claim (in the pre-pension era millions of low paid people made private arrangements though Friendly Societies, cooperatives and other methods), I accept that there will be a demand for some arrangement to help the poorest. This could be achieved by a means tested benefit (like a tax credit) that was paid directly into the pension scheme of their choice. This would also benefit those unable to work for health reasons or due to caring requirements, and would be applied to those signing on as unemployed.

There would of course be a hard core that refused to make arrangements. As long as the above arrangements were made clear, however, nobody would be able to pretend that they did not know that they might face poverty in old age. But no government will be able to ignore that poverty nonetheless. I would therefore suggest that the mandatory retirement age be scrapped, so that a person has chosen not to prepare for their future – or not to do so adequately –can continue working. There may be a case on anti-discrimination grounds for banning companies from having mandatory retirement ages too. Once people became too infirm to work, they could be dealt with through unemployment and/or sickness benefits.

Before anybody accuses me of being callous I would emphasise that honesty from the outset and a tax credit for the poorest would mean that only those who wilfully refuse to prepare for their retirement will find themselves in this predicament. If this is unpalatable, however, then the alternative would be to compel people to make arrangements: a pension could be mandatory for all workers, just as car insurance is for all drivers.

While some might suggest that not everybody would be able to make an informed choice about pension provision, I find this argument unconvincing – and indeed patronising. With the exception of those who are truly not capable of making decisions for themselves (and these are indeed exceptions and should be dealt with separately), everybody is able to make an informed pension choice, just as they make informed investment choices in other areas of their lives.

Some measure would be necessary to ensure that pension funds were not completely at the mercy of the markets. When I signed up for a defined contribution scheme, my pension provider arranged that in the last decade of the scheme, 10% of my funds would be moved each year from riskier, more rewarding investments to the safest investment vehicles (AAA bonds – which I would hope would mean government bonds considering how casually the rating agencies handed out AAA ratings over the past decade). This should ensure that nobody is caught out by a sudden market slump. It may be necessary to make this sort of protection mandatory.

These proposals are certainly a work in progress. Some of the ideas are not original, though the basic plan to taper the pension away is not one I have come across before. I make them in the hope of stimulating a discussion that may help me revise (or even abandon) what has for some time seemed like a good idea.

Ethical is not what these people think it is

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We should, of course, all act ethically all the time: the problem comes with who is defining what is ethical:

Some supermarkets have a "dismal" ethical record when it comes to supporting British farmers, buying local, seasonal and sustainable food and saving energy according a Government watchdog.

That definition of ethical coming from something called Consumer Focus, who appear to believe that it would be more ethical for me to support Farmer Giles, one who is already by any historical or global standard rich beyond the dreams of Croesus (and already swallowing flagons of taxpayers' money to boot) as opposed to spending my money with Farmer Obiang: one still stuck in the destitution of peasant farming and looking to modest trade with such as myself as a way of feeding and educating his children. 

This is not a notion of ethics which I find worthy of the name. How and when did nationalism of this, green, sort become ethical and internationalism, the acknowledgement that we are all human with the same rights and desires unethical?

More importantly, how did our system of governance become colonised by the purveyors of this new religion (for an ethical framework can indeed be so described)? And yes, this is our system of governance, Consumer Focus is a statutory body which we paid some £45 million for last year according to their accounts.

Roll on the regime change when we can have (and if we don't have then we'll just have to change regime again, won't we?) the Bonfire of the Quangos.