Part B: The lure of naive models in the era of financialisation (*)
[(*) For the rationale of this four-part series of posts, as well as for Part A of the series, click here.]
Preface: Part A of this four-part series of posts began by focusing on the problematic application of the analytic-synthetic method to socio-economic interactions. It argued that the economists’ penchant for ‘analysing’ complexity (through a process of breaking it down to its ‘constituent parts’, before synthesising the knowledge of those parts into a macro theory of the whole) delivers logically incoherent insights regarding the phenomena under study. But, remarkably, because the analysis itself is so complex (from a mathematical perspective), few can see through these models and realise their inanity. And given that the economists’ models have a great deal of utility for politicians and financiers, they become established as ‘conventional wisdom’.
B1. Is it a matter of dishonesty? On the process by which the economics’ profession becomes ‘captured’ by its theoretical artefacts
If I am right (that the analytic-synthetic approach of mainstream economics produces logical incoherence of untold complexity), how come so many smart economists pursue this practice, building on it fabulous careers in the best universities? Is there a conspiracy? No and no, is the simple answer. There is no conspiracy and it would be absurd to think that the economists involved knowingly indulge in theoretical subterfuge. So, what is going on? Here is what I think the answer is:
Economists are, by and large, an exceptionally open-minded people, willing to countenance any proposition, however farfetched, weird or even… leftwing. All they ask for in return is that the said proposition is embedded within their models. This ‘openness’ is made all the more significant by the fact that, undoubtedly, any conceivable ‘story’ can be told by tinkering with the economists’ axioms and hypotheses. Enticed by the prospect of unbounded theoretical possibility, the aspiring young economist delights in tinkering her way into the infinite vistas of potential economic narratives of everything and anything; she even revels in sailing the oceans of indeterminacy stirred up by her tinkering.
At some point, however, the fun must give way to publications, appointments and full induction into the profession. At that point, the lurking gatekeepers (supervisor, referees, Head of Department etc.) present her with a fresh condition: To be allowed into the priesthood, her models must have first achieved ‘closure’ (i.e. a restricted set of solutions, or ‘equilibria’ as economists call them); she must, in effect, submit them to the merciless tightening of her axioms in order to produce an ‘orderly’ narrative on what her model actually predicts.
The problem with squeezing a determinate solution out of her models is that to do so she must tighten her axioms in a manner that, at some level, defies logic. In the example mentioned in Section A2 of Part A the hapless economist must assume that certain unknowable probabilities are not only known but that everyone shares precisely the same estimate of them. But how can the unknowable be commonly known? The only answer the economist has is that, if the unknowable is not commonly known, then there can be no solution to her model (and no prediction of what will transpire). The honest retort, at that point, is to say: So what? If this is how things are, then clearly the model cannot predict anything.
Alas, the cost of admitting this is too great. Having already invested great energy and hope in her modelling, it takes a brave and tragic theorist to make this confession and call it quits. For if she does make this admission, her model will not be ‘closed’ neatly, her paper will not be published and her career will not take off. What tends to happen in the economics’ profession is the following:
- a tiny minority of practitioners ‘close’ their models reluctantly, tucking critical comments away in their papers’ footnotes, biding their time and, once tenured, turn into resident critics.
- some ‘close’ their models and steer clear of any controversy but, nonetheless, manage to retain the memory of how their profession’s imperatives whipped them back, from a complex and rewarding inquiry, to a paradigm devised for arid theorizing in the context of which a sophisticated theory of behaviour, of price formation, of crises etc. is as viable as a fire under a mighty waterfall
- the vast majority not only leave no stone unturned to ‘close’ their models, often with moral enthusiasm, but also sweep under the emotional carpet any memory of how their models’ ‘closure’ was bought at the price of a ‘haircut’ on logic.
Once young economists have compromised themselves in this manner, in order to become established in the academic profession (usually at Graduate School), they soon discover that they must do so again and again and again, if they are to stay the professional course. For once they are called upon to impart their wisdom in the amphitheatres, or to ‘advise’ government, business etc., their audiences demand a nuanced story of how their ‘closed’ models apply to the real world. Telling them that you can have either such a nuanced narrative or determinate models but never both requires the combination of intellectual honesty, mathematical acumen, and secure academic employment that only exceedingly rare birds have ever possessed. In their absence, the vast majority sustain the illusion of a nuanced, determinate theory by keeping shifting backwards and forwards between (A) ‘closed’ oversimplifications and (B) complex-yet-indeterminate models; and, last but not least, by (sub-intentionally) hiding all this under a rhetorical cloak which gives (even to themselves) the impression of a serene, unchallenged scientific authority.
B2. How the failed models became functional to the most toxic aspects of politics and financialisation
It is of course true that the very sight of a system of equations inspires a natural urge to solve it (and a feeling of disappointment when it proves over-determined). However, the economists’ zeal goes beyond that natural urge. The reason they are so hell bent on the endogenous determination of all variables (prices, quantities, wages, profits, but even social norms, moral entitlements, psychological utilities) exclusively on the basis of the initial, primitive data of their mathematical model, is that they understand the great rewards they have been receiving in the universities from having convinced the powers that be that they, the economists, are the only genuine social scientists. They have tasted the large rewards from ‘going it alone’; from appearing to be self-sufficient social scientists; ‘scientists of society’ who need no help from historians, psychologists, anthropologists or, God forbid, sociologists.
In this sense, economics’ closed-model approach is enforced by the invisible hand of academic rent seeking. This is how the (unseen to most) logical incoherence of their models (which is necessary in order to close them) is compensated for: By large academic research projects, salaries well above those of other social theorists and, importantly, an open communications’ channel with those in authority both in the financial sector and in government. Let us focus on these two channels: the one linking economic theorists to the world of political authority and the one connecting them to Wall Street et al.
Starting with the link between the economists’ models and financialisation, have you ever wondered where the financial engineers found the courage to argue that their own models could value the toxic derivatives that they were creating? The answer is devastatingly simple: The pricing models they used could only work (i.e. come up with a number denoting the ‘value’ of the CDO under construction) if their author imposed upon them the sort of tight axioms (or farfetched hypotheses) which the economists had learnt to adopt (against logic and reason) in order to ‘close’ their own economic models (in pursuit of academic success). Thus emerged a commonality of purpose: The most highly regarded mathematical economists, who turned a blind eye to the lack of logical coherence of certain assumptions necessary to ‘close’ their models, discovered that financial engineers who adopted these same assumptions made a bundle of money (by managing to turn their CDOs into tradable commodities). And the financial engineers, when needing to justify their models, pointed to the similar assumptions made by the best economists in the universities; indeed, by Nobel Prize winners…
Suddenly, economists bending the rules of logic in order to ‘close’ their models (for the sake of deriving determinate economic forecasts from them) entered into a loop of positive mutual reinforcement with the financial engineers who copied the economists’ axioms to compute the value of their financial products, and thus to enrich themselves and their employers. This feedback effect between economists and financial engineers proved exceedingly strong and highly lucrative for both. The economists involved, significantly, became all the rage in Wall Street. Guess which type of economist (the latter or those who kept questioning the logic of the said axioms) got all the perks, the large research budgets, a free pass to come-and-go between their University and some great bank at will and, lastly, the kudos within academia: Yes, the ones with a greater propensity to turn a blind eye to the logical flimsiness of the axioms necessary to ‘close’ the models.
Turning now to the link between these economic models and the political currents of the era, it is helpful to begin with an observation: Politicians who wanted to ride the wave of financialisation had a natural tendency to suggest to the electorate that what was going on was natural, that there were no risks involved of some Crisis (like that which, eventually, hit us), that even observed unemployment was OK, natural, part of the adjustment process that the labour market must go through. In technical language, mainstream politicians who posed as Wall Street’s blue eyed boys, had an interest in presenting current prices and interest rates are sufficient statistics by which to estimate the future as a linear extrapolation of the present. Financial markets were, thus, axiomatically conceived of as efficient mechanisms for spreading risk and distributing capital that no humble intellect could plausibly doubt or second-guess.
In all this, any serious discussion of the possibility of some Crisis was dismissed as non-sensical. And when one asked “Why is it non-sensical?” the answer took the form of a recapitulation of the models on which the forecasts and the valuations were predicated, without of course ever delving into the logically incoherent assumptions that most could not even discern.
In this sense, the economics profession’s ostracism of any analysis that ventures beyond the economists’ hidden axioms was tantamount to a subconscious strategy that brought great rewards to the economists involved, wonderful profits for the financial engineers that copied the same hidden axioms into the formulae that priced their derivatives and, lastly, re-election and long terms in office for the politicians whose policies were based on these models.
While the world is currently struggling to make sense of the tumult visited upon it by a particular strand of globalising capitalism, the latter’s best defence comes in the form of thousands of young economists being quickmarched headlong into academic obscurantism and socio-economic irrelevance. Instead of acting as the avant guard that will prise out the truth about the causes and nature of the current crisis, they are conscripted to this perpetual feedback mechanism which mutually reinforces (a) the current economic order and (b) the core of mainstream economics. Future historians undoubtedly will mark this out as our era’s most fascinating, and most tragic, evolutionary social dynamic.
B3. Epilogue: The curious success of theoretical and practical failure
Perhaps the greatest puzzle for our post-2008 times concerns the curious fact that nothing succeeds these days like grand failure. Economists draw their immense narrative power from an audaciously circular process of mutual reinforcement: faithful to its constitutive analytic method, which they juggle continuously in a manner that hides their implications (and, often, their logical incoherence), toxic economics retains its hold over the economics mainstream and rules itself out of engagement with the logic of really existing capitalism. Then, those who manage the latter supposedly on our behalf (politicians, bureaucrats, Wall Street), supra-intentionally, reward toxic economics with institutional power which helps it maintain a strict embargo on any serious scrutiny of either its own foundations or of really-existing capitalism.
It seems almost indelicate to point out that, while this feedback mechanism remains opaque and unexamined by the rest of us, the crony capitalism we live under and the toxic economics that supposedly sheds light on it will remain strangers who reinforce each other’s dominance as long as (a) economics remains, courtesy of its ‘closed’ model methods, innocent of the logic of crony capitalism and (b) the logic of crony capitalism spreads faster and deeper when economics’ method help it remain toxic.
NEXT: The next part in this series, Part C, will be entitled “Crisis and the temptation of Complexity Fetishism: The eurozone case.
- Yanis Varoufakis (2008). ‘Game Theory: Can it unify the social sciences?’, Organisational Studies, 29, 1255-77
- Yanis Varoufakis (2006). ‘Rational Rules of Thumb in Finite Dynamic Games: N-person backward induction with inconsistently aligned beliefs and full rationality’, American Journal of Applied Science, 2 (Special Issue), 57-60
- Shaun Hargreaves-Heap and Yanis Varoufakis (2004). Game Theory: A Critical Text, London and New York: Routledge
- Abstractions and morality in modern finance, Posted by Lisa Pollack on 23rd December 2011, FTAlphaville http://ftalphaville.ft.com/blog/2011/12/23/814381/abstractions-and-morality-in-modern-finance/