Monday, June 11, 2012

The failure of economics

George Soros made his BIG pile ($billion) shorting the British Pound on 16 September 1992 thereby driving it from the European Exchange Rate Mechanism.  It is estimated the speculators eventually cost the British taxpayers over 27 billion Pounds.  So now he occasionally makes an attempt to prove he isn't really a thieving soulless bastard by funding some lefty human rights organization.  On other occasions, he will try to prove he isn't being held captive by the same ideas that have recently caused so much financial chaos.

Having a BIG pile tends to absolve someone of many sins so Soros is still thought of as a financial expert.  And once in awhile, he actually gets something right.  This time, he is writing about the foolishness of economists trying to portray their business as a hard science like physics.  I could hardly agree more.  Over the years, I have done my best to ridicule the notion that economics is more of a hard science that the other social "sciences" like sociology or cultural anthropology.  Let me explain why.

Scholarly investigation involves two phases—digging up the facts and communicating them to others.  Economics tends to appear more "scientific" right out of the gate because many of its facts tend to be numbers already.  So you have hard data to use—like housing starts and factory utilization.  As most of us were taught in junior high, math is the language of science so manipulating these numbers using complex formulas makes economics LOOK scientific.  But appearances are indeed deceiving because it takes more than a lot of numbers to prove a point—something most economists wish the rest of us would ignore.

Here's the big problem.  Any communication involves getting an idea from one brain to another.  For example, writing encounters difficult problems because to make communication happen, the writer must choose his words carefully and formulate his sentences and paragraphs well.  Then, the reader must have a vocabulary at roughly the same level as the writer and be skilled at extracting meaning from print.  As we all know, this process often fails and even when it does work, its uses are limited.  It is impossible to construct a building from a written description so architects use drawings.  Musical notation was invented to communicate the ideas of sound.

When used correctly, math communicates ideas in ways that are extremely powerful because math works!  But like writing and musical notation, math has its limitations too.  For example, when describing a regular shape like a sphere, a mathematical formula is so powerful, you can take it to a machine shop and construct a sphere to extremely precise tolerances.  However, using math to describe an irregular shape like a car fender is much more difficult.  In fact, when using computers to instruct machine tools to make such an irregular shape, you wind up using the brute force of specifying thousands of Cartesian coordinates.  The folks who make animations have discovered it is almost impossible to mathematically describe the motion path of a running human so the preferred method is to affix data points to a real human and record them.

The point here is that if mathematical formulas cannot describe something as simple as irregular shapes or motions, what makes the economists believe that their mathematical models can describe something as complex as human behavior?  The truth is, their complex-looking models cannot predict much complexity and so they tend be be vast over-simplifications of reality.  These models might be more interesting than the formula for a sphere—but not by much.  And it is utterly amazing what economists leave out of them.

My favorite example is aesthetics.  That appearance is economically important is beyond rational debate.  Beautiful whores make much more money than ugly ones, seashore properties sell for much higher prices than properties next to a landfill, Apple computers sell for a significant premium simply because they are created by industrial designers with a lot of talent, etc.  From eyeglasses to sports cars and a lot in between, looks make a significant economic difference.  Yet TRY to reduce this economic fact to a mathematical formula.  It simply cannot be done.  The best an economist can do is tell you to check out the data generated by the market.  Well duh!  By the time something has been evaluated by the markets, virtually all the work necessary to create a product has been done.  The best an economist can tell us is that aesthetics is merely an add-on that commands a premium over what something would fetch according to his "law" of supply and demand.  So by leaving out aesthetics and how beautiful things are generated, the economist describes only about 15% of economic reality—the boring 15% at that.

We have reduced the economics profession to a bunch of math nerds who somehow believe that by using ever more complex formulas, they can describe reality.  It doesn't work like that.  Yet we still follow these charlatans over the cliff because they have convinced us their complex math makes them as scientific as physicists.  Maybe they should try musical notation (just kidding!!!)

Anyway, Soros gets it on some level that modern economic theory has failed and gives some pretty sound reasons for his analysis.  However, if you read his whole speech it winds up concluding that the Euro is dead unless Germany spends its wealth to save it.  So the man proves that even starting with some good insights, he comes to a bogus conclusion simply because he cannot escape the trap of his thinking as a currency speculator.

Ah yes, Institutional Analysis—my nominee for the official language of economics.

The Full Text Of George Soros' Famous Speech

Festival of Economics
June 2, 2012
Trento, Italy

Ever since the Crash of 2008 there has been a widespread recognition, both among economists and the general public, that economic theory has failed. But there is no consensus on the causes and the extent of that failure.

I believe that the failure is more profound than generally recognized. It goes back to the foundations of economic theory. Economics tried to model itself on Newtonian physics. It sought to establish universally and timelessly valid laws governing reality. But economics is a social science and there is a fundamental difference between the natural and social sciences. Social phenomena have thinking participants who base their decisions on imperfect knowledge. That is what economic theory has tried to ignore.

Scientific method needs an independent criterion, by which the truth or validity of its theories can be judged. Natural phenomena constitute such a criterion; social phenomena do not. That is because natural phenomena consist of facts that unfold independently of any statements that relate to them. The facts then serve as objective evidence by which the validity of scientific theories can be judged. That has enabled natural science to produce amazing results.

Social events, by contrast, have thinking participants who have a will of their own. They are not detached observers but engaged decision makers whose decisions greatly influence the course of events. Therefore the events do not constitute an independent criterion by which participants can decide whether their views are valid. In the absence of an independent criterion people have to base their decisions not on knowledge but on an inherently biased and to greater or lesser extent distorted interpretation of reality. Their lack of perfect knowledge or fallibility introduces an element of indeterminacy into the course of events that is absent when the events relate to the behavior of inanimate objects. The resulting uncertainty hinders the social sciences in producing laws similar to Newton’s physics.

Economics, which became the most influential of the social sciences, sought to remove this handicap by taking an axiomatic approach similar to Euclid’s geometry. But Euclid’s axioms closely resembled reality while the theory of rational expectations and the efficient market hypothesis became far removed from it. Up to a point the axiomatic approach worked. For instance, the theory of perfect competition postulated perfect knowledge. But the postulate worked only as long as it was applied to the exchange of physical goods. When it came to production, as distinct from exchange, or to the use of money and credit, the postulate became untenable because the participants’ decisions involved the future and the future cannot be known until it has actually occurred.

I am not well qualified to criticize the theory of rational expectations and the efficient market hypothesis because as a market participant I considered them so unrealistic that I never bothered to study them. That is an indictment in itself but I shall leave a detailed critique of these theories to others.

Instead, I should like to put before you a radically different approach to financial markets. It was inspired by Karl Popper who taught me that people’s interpretation of reality never quite corresponds to reality itself. This led me to study the relationship between the two. I found a two-way connection between the participants’ thinking and the situations in which they participate. On the one hand people seek to understand the situation; that is the cognitive function. On the other, they seek to make an impact on the situation; I call that the causative or manipulative function. The two functions connect the thinking agents and the situations in which they participate in opposite directions. In the cognitive function the situation is supposed to determine the participants’ views; in the causative function the participants’ views are supposed to determine the outcome. When both functions are at work at the same time they interfere with each other. The two functions form a circular relationship or feedback loop. I call that feedback loop reflexivity. In a reflexive situation the participants’ views cannot correspond to reality because reality is not something independently given; it is contingent on the participants’ views and decisions. The decisions, in turn, cannot be based on knowledge alone; they must contain some bias or guess work about the future because the future is contingent on the participants’ decisions. more


  1. Did not know how Soros made all that money until now. Thanks for the info.

  2. Interesting speech, especially this part--
    "Among other things, I developed a model of a boom-bust process or bubble which is endogenous to financial markets, not the result of external shocks. According to my theory, financial bubbles are not a purely psychological phenomenon. They have two components: a trend that prevails in reality and a misinterpretation of that trend. A bubble can develop when the feedback is initially positive in the sense that both the trend and its biased interpretation are mutually reinforced. Eventually the gap between the trend and its biased interpretation grows so wide that it becomes unsustainable."

    Because what happens in the financial market casino is firms manipulate the market to both create these gaps and then implode them when their financial schemes are in position to profit. And of course, it is much easier to destroy something than create something of value, so the entire financial market now is based on destroying investments instead of investing in producers. Just look to the multi-trillion dollar derivative there even one dollar invested in there that is based on positive production?

    The entire financial industry not only needs to be divided from the true banking industry, it needs to be dismantled and eliminated as being an anti-social activity. It not only does not create jobs or add value to society, it destroys it...always has and always will, but when it was smaller 25 years ago it was hidden in the fog of real investment.

    The veil should now be lifted, investment banking has become anti-social, far more destructive than guns and drugs...but there are none so blind as those whose jobs (and political careers) are now dependent on the ill-gotten monetary gains of this industry...and none so blind as those who will not see.

  3. Am I reading this wrong? Soros appears to be saying "I call this X..." and "I developed a model for X...", and all these X things were done by other people. For example, a boom-bust model using dynamical system modeling based on Minksy was developed by Steve Keen (and probably some others before him). The term "reflexivity" has been in use in academic sustainability circles for well over a decade and describes exactly what he outlines above. At least he references Popper, but Popper was hardly the first person to comment on how our mental model of the world diverges from reality. Basically, did anyone else read this and get the impression that Soros was trying to pass off others' ideas as his own? Is he just that intellectually dishonest, or am I being unfair and reading too much into his choice of words?

    Jonathan: If you want to see an economist developing a mathematical model that actually seems to work (at least, for tracking money/debt dynamics), Steve Keen is the guy to look for. He's developed a simulation that uses double-entry bookkeeping (backed by differential equations) to represent monetary flows in an economy. This post is a little old, as he's updated things a bit since then.

  4. Thanks guys.

    As for the Steve Keene model, it seems like another instance that tracks money. Yes, math can do this. What I would like to see is a math model that could have predicted what happened to Solyndra. VERY hard to model something that involves a product that isn't on the market yet. Which is mainly my point. Easy stuff—math. Hard stuff in the real economy...I go with IA.

  5. Agreed on Keen--though it's a start, and being able to explain how the monetary portion of the economy functions is a valuable addition. For new products/technologies, I agree with you that math really can't model them that well--or, if it can, you can't use it to predict the future. Initial conditions of highly nonlinear systems, massive data requirements, and so on make it appear impossible. The best we can do is understand the conditions that foster new products/new innovations and make sure those conditions prevail.

    Oh, and another piece of reading that you might find interesting: "Of Flying Cars and the Declining Rate of Profit" by David Graeber

    1. I just read the essay of the disappointment folks seem to feel because the flying cars never showed up. I once actually met Molt Taylor at an EAA convention—the guy who actually held a USA patent on a flying car. This was in the mid 70s and he was an odd duck who somehow believed that there was some sort of conspiracy to defeat his flying car. The fact that no one in their right mind wanted to go out on a highway in something light enough to fly powered by a spinning propellor seemed just a minor detail to old Molt.

      That was the problem with science fiction—we were supposed to just ignore the real problems. Star Trek was about sitting on the bridge in futuristic outfits. I probably could have watched that show if just once, someone had to fix a broken toilet—without the right parts. And of course, the energy just came from nowhere. As I once told a friend, if I could have believed the bullshit of Star Trek, I could have believed the miracles in the Bible which would have saved me a host of arguments with my old man.

      Of course, my "bad" attitude about sticking to the realm of the possible has gotten me lectures over the years. "How do you KNOW something is impossible?" I would be asked by folks who thought I should be ashamed for my desire to squelch "creativity." And so I have watched people claim that 200 mpg would be possible if only we reformed our patent laws or that the moon or asteroids should be available to mine scarce minerals. And while the idiots babbled, we lost our chance to solve real problems with known methods. I remember once screaming at one of the fools, "Why do you want to believe the unbelievable when there are almost limitless possibilities within the realm of the doable?"

      I want you to know that "2001" is one of only two movies I actually walked out of. ("Caligula" was the other and there was a woman involved.) I am sorry, Kubrick wasn't a genius and his movies predicted absolutely NOTHING!