JDN 2456563 PDT 15:10.

A review of Animal Spirits by George A. Akerlof and Robert J. Shiller.

When I first came to CSULB about a month and a half ago, we had an orientation for graduate students. One of the faculty members there (Seiji Steimetz, for whom I am now a graduate assistant, and whom I have come to adore) asked us all a question: “What kind of research do you want to be involved in?” Most of the students didn’t have an answer. I had an answer I didn’t quite know how to explain, so I basically coined a new term: “Cognitive macroeconomics. Basically, what happens to our understanding of the macroeconomy when we stop assuming people are rational—because they’re not?” He replied, “Like prospect theory to explain inflation?” That wasn’t quite right, but it was a more accurate response than I’d expected. Actually that would count as cognitive macroeconomics I think; it’s just not in particular what I had in mind. “Yeah, something like that,” I said.
Animal Spirits is, in all but name, an introductory textbook on cognitive macroeconomics. It is written in a very readable style, and uses hardly any math; but it marks a paradigm shift in macroeconomic theory. Instead of assuming that workers and capitalists are rational, let’s study how they actually think and behave.
Daniel Kahneman and Daniel Ariely (collectively I shall call them “the Dans”) basically founded cognitive economics, but they are really cognitive microeconomists. They talk about issues at the level of individual firms and consumers. I find neoclassical microeconomics mind-numbingly boring; cognitive microeconomics is more interesting—and more valid—but it still lacks the glamor of large-scale impact that macroeconomics promises. If we want to live by Keynes’s “the world is ruled by little else”, it is in macroeconomics that we will do so.
Indeed, it could be argued that Keynes himself was a cognitive macroeconomist; after all, he was the one who coined the term “animal spirits” from which the book draws its title. But the paradigm shift didn’t happen then, because Hicks distorted Keynes’s vision into something quasi-neoclassical, making what could have been a fundamental advance into a incremental improvement. It is as if we shoehorned Newtonian physics onto Ptolemy’s epicycles, or told Darwin that his theory was useful for other animals, but God still made human beings in his own image. (Come to think of it, a lot of people still think that, don’t they?) I doubt Keynes would have recognized what we know call “Keynesian”.
I actually know George Akerlof’s older brother, Carl Akerlof; he’s a physicist at Michigan (whom I interviewed for the Physics Historical Project). Hopefully someday I’ll get to work with George as well; his work sounds like almost exactly what I want to be doing.
Part One explains the five “animal spirits” Akerlof and Stiller think are most important: Confidence, fairness, corruption, money illusion, and stories. The first three are relatively self-explanatory; the fourth is familiar to economists ever since (you guessed it) Keynes, though it has fallen out of favor.
The fifth I think is worth exploring further, since it may actually be the most important. Cognitive scientists have basically established that human short-term memory comes in two basic data formats, image and audio. The latter is literally audio, basically a two-second ring buffer: You can remember longer sentences if you say them faster. The former is not a bitmap image, but more like vector graphics; you can scale and stretch the image in your mind, but it has limited detail. To say that the human brain stores in SVG and WAV is only a slight exaggeration.
But long-term memory takes a fundamentally different format; I think the best way to describe it is to say that the native data format for long-term memory is narrative. We use stories to organize our own past, our culture, our ideas for the future—even our scientific theories. This is why epic poems were so successful in ancient times, and novels are so successful today; they link into this fundamental data format. (Epic also makes use our two-second audio buffer through techniques like rhyme and meter.)
The universe, by contrast, does not appear to be made of stories. Sometimes things happen randomly. Often the cause is unavailable to us. Most historical events are driven by slow pressure from millions of sources, with no clear “Great Man” to be the hero or the villain. Reality is unrealistic, and sadly, the good guys don’t always win.
Animal Spirits uses this to explain the observation that Nassim Nicholas Taleb made in The Black Swan: Why do pundits always come up with a story to explain any random fluctuation? Because human beings like to organize their world in terms of stories.
The second part of the book tries to apply these “animal spirits” to real-world problems in macroeconomics; this is where the book comes up a little short. Akerlof and Shiller sketch out a plausible qualitative account of what happened in the 2008 crash and the Second Depression, and offer some basic suggestions on how we might fix the problem… but much of what they say is vague, and none of it offers sharp, quantitative predictions.
This is the one criticism neoclassicists make of cognitive economics that I do take seriously: It’s easy to show flaws in the current models—but do you have a better one? Neoclassical economics succeeds as a science in one sense: It is wrong. It has gone beyond not even wrong and actually made it to wrong—it makes precise predictions that are incorrect. Cognitive economics isn’t quite at that point yet; we have the potential to make predictions that are correct, which is of course the goal; but right now we aren’t making a whole lot of predictions at all, and the ones we are making aren’t very precise. Akerlof and Stiller think they can explain all the recessions of the past (or rather specifically the non-oil-related peacetime recessions) by their model; and that would be useful, to be sure. But can you predict or prevent the next recession? With enough free parameters you can fit an elephant; it’s easy to make a model that fits the past. The trick is making a model that fits the future. (This is also why “maximum likelihood” is sort of a perversion of Bayesian methods. The maximum likelihood is basically just what you actually found. What you want is the maximum probability, and for that you need a prior distribution.)
They have precise models that give the wrong answer. We have imprecise models that give answers somewhere near the right answer. So we’re not quite there yet. We need to make precise models that give the right answer.
That is why this is only the dawn.

JDN 24565554 PDT 20:54.

A review of The End of Poverty by Jeffrey Sachs

This should have been one of the greatest books ever written. It should have been the rallying cry for a radical new approach to global development, a seminal advance in what it means to do economics—it should have been quite literally a book to save a billion lives.
And make no mistake, Jeffrey Sachs has a project that really does have the potential to have that kind of impact. But The End of Poverty doesn’t quite manage to sell that project, for reasons that are not all that easy to pin down.
I think part of the problem is that Sachs was trained as a neoclassical economist and hasn’t quite managed to break free from this indoctrination. This makes Sachs, and thus The End of Poverty, of two minds: On the one hand he wants to say that the Washington Consensus has failed, capitalism is in crisis, and we are approaching a fundamental paradigm shift in development economics. On the other hand, he keeps talking about market incentives and rational expectations, and dismisses socialism as an obvious failure—even though many of the reforms he wants are in some sense socialist reforms. I couldn’t find the passage when I looked back to quote it, but there’s even a section where he talks about the shift from communism to capitalism and says “only then did unemployment emerge” and makes it sound like a good thing. It’s really bizarre; rather than saying, “Yes, these workers had to bear the pain of unemployment, but in the long run the market reforms were necessary and made everyone better off,” he actually speaks as though he thinks laying off all those state employees was intrinsically beneficial.
At the end of the book he calls upon us to see past narrow self-interest and work to create the world we want to live in. This is exactly right; and like him, I do believe it is possible. But in earlier pages he talks about how collective farms obviously fail because they don’t have market incentives… and I find myself asking, “Well, why couldn’t they see past narrow self-interest?”
Much of what Sachs says is not only right, it is desperately needed. His message sounds like a pipe dream—ending poverty in less than 20 years?—but his economic sophistication is undeniable. He not only shows how it can be done, he calculates how much it would cost and what would be the most efficient way to pay for it. The number he derives is now widely accepted by development economists, yet so few laypeople comprehend it: $100 billion per year. 0.7% of GDP. That’s how much the United States would need to spend; the rest of the First World, mostly Europe and Japan, would add another $100 billion. And that’s it. That’s all it would take. For less than 1% of our total income, we could end extreme poverty forever.
Now, to be fair, this is extreme poverty—it’s the kind of crushing poverty that leaves you starving in a rusting shack made of corrugated steel in a slum by the train tracks in Ghana. Sachs is not proposing to eliminate relative poverty—the dramatic difference between the richest and the poorest in the US—and it’s not clear whether his plan would even fully eradicate absolute poverty—the state in which some people don’t have enough to meet their basic needs. There are some things that might be considered “basic needs”, especially in a First World society (like electricity, transportation, and dentistry) that might still remain out of reach for some of the world’s poor. But Sachs’ proposal really does have a serious chance of ensuring that everyone in the world has food to eat, water to drink, shelter to live in, and basic medical care. Sachs asks us to imagine a world without starvation or malaria, and then provides concrete steps we could take right now to get us closer to that world.
The problem is, Sachs appears torn between the neoclassical concept of selfishness and an idealistic concept of altruism. What he needs is a fundamentally new paradigm, something that is neither selfishness nor altruism—what he needs is what I call the tribal paradigm. Humans are not selfish individual utility maximizers; indeed, one would have to be a psychopath to act that way. But nor are we selfless altruists, giving everything we have to anyone who asks. The default setting for human moral intuition is tribalism—it is to think in terms of an “in group” that we are altruistic toward, and an “out group” that we are not. Put another way, our unit of rational action is the tribe, not the individual.
I’m actually working on how I might work this into an empirical paper or an econometric argument—perhaps my master’s thesis will ultimately be titled, “The Tribal Paradigm”—but for now, let me offer some illustrative examples.
Are racists selfish? Is it acting in your self-interest to hate Black people? No, it isn’t. Indeed, the reason neoclassicists have thus far utterly failed to explain or respond to racism is that it couldn’t exist within their model of human behavior. There would always be a market incentive to not be racist, because whatever the color of their skin, the color of their money is the same. But does this mean racists are altruistic? It certainly seems odd to say so; if they’re such altruists, shouldn’t they be nicer to Black people? The answer is that they are tribalists—they are altruistic to their in-group (White people) and not to those outside it.
Here’s another example, particularly relevant to economics: We often speak of “the firm” or “firms” as economic agents with well-defined interests and actions. Sometimes we speak of “the government” in a similar way. But for fundamental game-theory reasons, there’s no reason to think that the interests of a firm are the same as the interests of any individual in that firm, or even necessarily an aggregate of all their interests put together. Yet we can with some accuracy predict the behavior of firms by assuming they are self-interested agents; how? Because sometimes people identify with the company as their tribe. And let’s be honest: Who in the US government doesn’t think of the US government, or the American people as a whole, as their tribe? You have to at least convincingly fake such tribalism to even be elected—we call this “patriotism”.
I certainly hope Sachs succeeds. I just wish he were a little better at selling it.

A review of The Trouble with Diversity by Walter Benn Michaels

JDN 2456543 PDT 19:54.

Walter Benn Michaels is really not the best person to be addressing the philosophical, political, and economic issues involved in identity politics: After all, his PhD is in English and he’s best known as a literary theorist. His writing style is competent, but sometimes a bit verbose and repetitive. He does not appear to have learned that brevity is the soul of wit(though to be fair, that is a lesson I’ve never learned very well myself). Worst of all, he acknowledges the support of Stanley Fish, who is insane.

Still, his basic message is sound, and much-needed: Identity politics is a dead end. Dividing people up into genders, sexual orientations, ages, and worst of all "races" and "cultures" (which, as he rightly points out, are scientifically nonsensical categories) does not advance the goal of social justice. It is at best orthogonal and at worst a dangerous distraction.

Indeed, Michaels writes as if he thinks that this might be intentional, some kind of right-wing conspiracy to make us all talk about diversity so that we ignore economic injustice. I find that unlikely; while certainly there are many people who don’t want us talking about economic injustice, I don’t think that they are the ones largely responsible for advocating diversity. No, I think diversity and identity politics were well-intentioned projects of social justice that took on a life of their own, accidentally triggering a deep human instinct for tribalism that overrode our (evolutionarily much more recent) rational principles of justice.

Michaels is apparently one of a select few, myself included, who realize just how divisive identity politics really is. Most LGBT people I’ve talked to strongly disagreed with what I said about Lavender Graduation, though disabled people I’ve talked were mixed on their responses to what I said about the disability community. Yet the more I think about it, the more I stand by what I said; the goal of equality is not to have me acknowledged as special for being bisexual, it’s to be left alone because being bisexual doesn’t matter. It’s not to being respected for the diversity my migraines create; it’s to cure my migraines.

And there is something I like about the style of the book; Michaels has a way of making the truth obvious, making it seem like we should have understood these things long ago. Examples follow.

If you, like me, have long felt that diversity is overrated or maybe even a totally wrong approach; if you have recognized how nonsensical the categories of "race" and "culture" are only to be rebuffed for being an anti-liberal bigot; if you have tried to find solutions to the global problems of poverty and inequality only to be told that feminist solidarity or "black power" is more important—this book is probably worth reading. And on the other hand, if you think we’re all insane, and obviously diversity is wonderful, and we should respect and cherish "the black experience" and "Asian culture", this book is definitely worth reading. Some of the "differences" you are talking about aren’t even real, and those that are real (like gender and sexual orientation) aren’t particularly worth celebrating.

Page 15, on how the ultimate goal of social justice must be a world where differences simply don’t matter: "An important issue of social justice hangs on not discriminating against people because of their hair color or their skin color or their sexuality. No issue of social justice hangs on appreciating hair color diversity; no issue of social justice hangs on appreciating racial or cultural diversity."

Page 43, on why the idea of "black culture" is nonsensical: "The problem is that
the minute we call black culture black, […] in order for a sentence like ‘Some white people are really into black culture’ to
make sense, we have to have a definition of white and black people that is completely independent of their culture."

Probably my favorite, on page 81: "Although no remark is more common in American public life than the observation that we don’t like to talk about race, no remark—as our self-description and the very existence of these [diversity] rankings suggest—is more false. […] In fact, we love to talk about race." We clearly do, don’t we?

This one on page 88 hit home because I am an upper-middle-class recipient of several merit scholarships, but I can’t really disagree with it: "Another way you can put it is that where need-based scholarships give money to the poor, merit-based scholarships give money to the rich."

Page 122, in reference to companies apologizing for their past involvements in slavery and the Holocaust: "Apologizing for something you didn’t do to people to whom you didn’t do it (in fact, to whom it wasn’t done) is something of a growth industry." We think of this as perfectly normal, yet Michaels is quite right that with a bit of thought it’s baffling. "Chase" was supportive of the Nazis? But it has completely different staff and management now; what is this "Chase" of which you speak?

On page 126, Michaels points out how we have it exactly backward; we think apologies make sense and restitution doesn’t, when quite the opposite is the case. "[…] the people who did the bad things can’t be punished. But their descendants can give back the money they should never have had. Apologies are irrelevant, but restitution is not."

Page 136: "The majority of Americans, for instance, think there should be no inheritance tax, that is, they think that hard work and ability should make no difference whatsoever when it comes to distributing the billions of dollars that change hands from one generation to another."

On page 139, he captures something I’ve been trying to explain to economists for years; people aren’t being irrational just because their being altruistic; indeed, it doesn’t even follow that they are irrational just because their beliefs are wrong. "And there really isn’t any contradiction in thinking that it is more important to stop abortion than it is to further your economic interests."

Page 140: "The real contradiction is between our support for equal opportunity and our support for all the things that make our opportunities unequal." (Or, I might add, opposition to things that would make opportunities more equal, like welfare, food stamps, basic income, and socialized medicine.)

This passage on page 144 reminded me most of all of Johnathan Haidt and why I hate him: "[…] they also prefer to understand our political differences as differences in identity rather than ideology, as differences in who we are rather than what we believe."

He makes a lot of really good points about how the "crisis" of disappearing languages and cultures is really not a serious problem; after all, people are giving up these languages and cultures voluntarily for the most part. Even when that isn’t the case, the coercion is wrong, but why is it bad the "lose" the "culture"? And why are we focusing on these issues instead of the much larger problem of poverty and economic inequality? "[…] the disappearance of languages is a victimless crime. The disappearance of jobs isn’t."

Michaels is hard to pin down as liberal or conservative; in some sense he’s far left, but he often disagrees with standard liberal positions. He supports affirmative action only as a "better than nothing" system that should be replaced by income-based reforms, and I concur.

He also has some bad things to say about both liberals and conservatives, like on page 173: "And when people do want to have the debate (when they want to talk about inequality instead of identity) they are criticized by the right as too ideological and by the left as insufficiently sensitive to the importance of race, sex, gender, et cetera—that is, as too ideological."

He brilliantly takes down the sort of mealy-mouthed religious relativism that Dr. Hoffman spouted. On page 174: "Only someone who doesn’t believe in any religion can take that view that all religions may be plausible considered equal and that their differences can be appreciated." On page 177: "And since politics to some degree involves your beliefs—you run for office in part by expressing and arguing for them; you govern more or less according to them—it can make no sense to say that religion should be kept out of the public square." I also made a similar point in "Is Secularism Sustainable?" Secularism effectively depends upon believing in atheism, but not being willing to make atheism your national policy.

This is my second-favorite, on page 189: "While the debate over whether America should be Christian is a step in the right direction, a debate over whether America should continue to worship at the altar of the free market would be better still."

JDN 2456534 PDT 15:58.

A review of Debunking Economics: The Naked Emperor Dethroned?
by Steve Keen.

The basic message Keen is trying to
send is a vitally important one: Neoclassical economics is failing.
Models based around rational agents and static equilibrium simply
fail to represent the real world, and and as a result give
policymakers a false sense of security against economic crisis.

The way Keen delivers this message is
by avalanche: Page after page, chapter after chapter, he tears apart
neoclassical economics piece by piece. His goal, indeed, is not to
show that the theory is wrong—refuting even a few assumptions
or equations would do that—but rather to show that it is rotten
to the core, that virtually every assumption and every equation is
defective.

And this, I think, is Keen’s greatest
failing. Some of the walls he tries to tear down are stronger than he
imagines them to be, and this draws attention away from the very real
gaps in the walls of the citadel.

He also has this weird obsession with
"what they originally meant"; he clearly knows a great deal
about the history of economics and economists, and so I’m inclined to
think he’s basically right about what Keynes, Marx, Von Neumann, etc.
originally meant; but so what? These men were brilliant, and many of
their insights are useful, but they were still wrong about a lot of
things. Even Darwin and Einstein made mistakes, and Marx was no
Darwin.

The first two chapters are
introductory material, in which he appeals to the reader (in a rather
melodramatic fashion) to be the change that economics needs.

In chapter 3, he examines the
theory of consumer behavior, and in particular focuses on several
mathematical results showing that preferences cannot be aggregated.
This is of course absolutely correct; the notion that we can get the
preferences of society by simply adding up the preferences of
individuals is profoundly naïve, and indeed the whole point of
Arrow’s
Theorem is that you can’t
do that. This certainly does damage neoclassical economics severely,
since the whole "New Keynesian synthesis" of modern
macroeconomics is based upon aggregated demand functions that are
simply the sum of individual demand functions.

The problem can actually be
avoided by accepting something classical economists did but
neoclassicists fear: cardinal
utility. If utility
isn’t just an ordering, but actually a measurable value, then
aggregation becomes much easier. Indeed, as I often like to point
out, Arrow’s "Impossibility" Theorem simply assumes a
priori that you’re not allowed
to do range voting, even though range voting is in fact a real system
that real institutions (like Amazon.com and much psychology and
sociology research!) use with great success. Include range voting as
an option, and the "impossible" conditions Arrow presents
turn out to be actually quite easy to satisfy. They still don’t
guarantee a negative-slope demand curve, but so much the worse for
negative-slope demand curves, because we know for a fact that some
goods increase in aggregate demand when their price rises. (Gold,
oil, diamonds…) Mathematically that system is unstable? Yes, yes it
is; and so are markets for these commodities. That’s an
empirically valid prediction.

Now, the original reason
cardinal utility was abandoned was that it appears unmeasurable; what
are the units? How do you detect utility? Well… actually it’s not
that hard. How many papercuts would you be willing to endure for a
delicious meal? How many electric shocks would you accept to get an
HDTV? If those examples sound silly, how about these: How many hours
would you be willing to work, in order to buy a nicer car? How long a
commute are you willing to bear to save $100 on monthly rent? These
are questions that we not only can answer, we do and
must answer in our
daily lives. If your answers
aren’t precise, chalk that up to the inherent uncertainty in the
universe. At the very least you should be able to place some bounds
on your answer: The car is not worth less than 100 hours of work
(spread over a year), nor is it worth more than 100,000. I’d
definitely accept another 10 minutes to save $100, and I definitely
wouldn’t accept another 2 hours.

Chapter 4 is the chapter Keen
says drew the most criticism in the first edition, and I can see why:
It’s clearly wrong. He
tries to argue that there is no difference in pricing between
competitive markets and monopolies, based on the fact that the
aggregate total of firms would maximize their profits if they acted
like a monopoly.

Well, yeah, of course they
would; they’d be effectively a monopoly. The
whole point of perfect competition is that the firms can’t collude
effectively, so they make their decisions independently. With that
assumption in mind, you can show mathematically that they’ll charge a
much lower price than the monopoly would. In effect, they are trying
to exploit their competitors, and being exploited in return.

Keen does point out something
rather important: The slope of the marginal demand curve for a
competitive firm and the slope of the demand curve for a monopoly are
exactly the same. That
is indeed exactly right; since the firms act independently, producing
one more unit leads to an increase in the total production of, you
guessed it, one unit—and thus drives down the price at which
all units can be sold. The claim that the marginal demand curve is
"effectively horizontal" as many neoclassicists assert is
simply untrue; one more unit of production is one more unit of
production.

What Keen fails to realize is
that the assumption of "effectively horizontal" isn’t
necessary to show that competition drives prices to equilibrium. I
actually worked out the full algebra for the price charged and
quantity produced by an n-oligopoly,
and sure enough, as n goes
to infinity, the price and quantity converge to the equilibrium.

Thus, Keen tried to argue that the
basic mathematics of neoclassical economics are wrong, and failed
miserably; the math works just fine, thank you. Where Keen should
have focused is on the absurdity of perfect competition as a
real-world phenomenon: It requires not only an infinite number of
consumers and firms (where at least we can get pretty good
approximations with millions of customers and thousands of firms),
but also perfect information, zero externalities, and perfect
neoclassical rationality—which is to say, the behavior of an
omniscient psychopath. Neoclassical economics does not model the
behavior of human beings; it models the behavior of amoral gods.

Similarly, Keen tries to make
the bizarre argument that profit is not maximized by setting marginal
revenue equal to marginal cost. That’s not something neoclassicists
assumed; that’s a calculus theorem. P
= R – C. max P → dP/dq = 0 = dR/dq – dC/dq →
dR/dq = dC/dq.

He claims that this disappears
if you include time as a variable; no, it does not. The math gets
more complicated (I probably already glazed some eyes with the
above), but when you solve that Lagrangian you still get marginal
revenue equal to marginal cost. If you can produce something for less
than you can sell it for, you do so; and you sell it, and you make
money. If it costs more to make than you could sell it for, you don’t
make it. And the point where you change your mind (assuming things
are continuous, which is a pretty good approximation for large
corporations) is the point at which the price you sell it for is
exactly equal to what it cost you to make it! He babbles some
nonsense about how you want to maximize the rate of change
of profit, but that’s simply not
true; you want the rate of change to be zero, because
that means you’ve hit a local maximum of the function.

Once again, Keen could simply
have pointed out that firms are not optimal
profit-maximizers, and it’s not clear that it would be a good thing
if they were. Nor is it realistic to separate the market into
individual pieces and solve the "partial equilibrium", as
though raising wages for auto workers wouldn’t affect the price of
real estate in Detroit, or an increase in the price of oil wouldn’t
change the cost of shipping from China.

Chapter 5 is better. Keen rightly
points out that economies of scale are the norm, not the exception;
and the fact that neoclassical models can’t handle them is so much
the worse for neoclassical economics. He compares the strange "short
run" in which firms somehow can change their labor usage without
changing their capital consumption with the empirical reality of
business, that buying more capital is often easier (and certainly not
systematically more difficult) than hiring new talent. Which takes
more effort and time, do you suppose: Buying a new copy machine, or
hiring a new secretary? Installing a new computer, or finding a new
programmer? Neoclassicists treat hiring as if it simply involved
pulling someone off the street, and capital purchase as if it
involved building a new factory from raw materials.

In chapter 6, the topic is labor
and how wages need not equal marginal productivity; he points out
that this result is derived from many unrealistic assumptions—most
of all that capitalists have no more market power than laborers, and
that people decide how much to work as a trade-off between money and
leisure. In fact, even with that
assumption, it’s possible to derive the result that workers won’t
vary their hours based on pay rates (a "vertical labor supply
curve")—and here’s the best part: To get that result, all
you need to do is add the extra assumption of homothetic
preferences, which is
normally something neoclassicists assume all the time. It’s a totally
unrealistic assumption of course; but isn’t it interesting how they
suddenly abandon the assumption when it leads to a conclusion they
don’t like?

On the other hand, Keen spends a
lot of time in this chapter criticizing the idea of a "social
welfare function"
that takes only GDP as input and outputs a utility score for the
whole society, and that really doesn’t seem to belong in a chapter
about labor markets. He is of course absolutely right that this is
ludicrous; the distribution of that GDP is vital to deciding how just
and happy our society will be, and there are other factors as well.
But I don’t see how it’s necessary to assume a social welfare
function in order to argue that wages equal marginal productivity.

Chapter 7 is a mixed bag; some
of Keen’s arguments are cogent, while others seem weak. He spends a
lot of time on Sraffa’s esoteric argument that capital should be
priced as "dated labor" discounted at the average
risk-adjusted rate of profit. As far as I can tell no actual capital
is ever priced this way, certainly not consciously; nor is it clear
to me that this would be a normatively good way of pricing it. It
seems to me that capital should be priced at the point where marginal
value equals marginal cost, just like anything else; and no CEO is
concerned with the average risk-adjusted rate of profit for the
economy, but rather for the amount (not
rate, amount) of
profit he himself can make on any given activity. To see that it is a
question of amount and not rate, which would you rather do: A, buy
something for $0.01 you could sell for $1, or B, buy something for
$10,000 you could sell for $15,000? The former way you make a 9900%
profit… of $0.99. The latter way you make a 50% profit, but it’s
$5,000. If you could repeat them both infinitely, you’d choose the
former; but you can’t, so why does that matter? Given the choice
between A or B, done once, you choose B.

If you were trying to assess the
value of the capital
this way, that’s wrong as well; its value is the amount of utility it
can provide by what it does, including the labor it saves, the
products it makes, and any joy it produces directly.

Fortunately, Keen is right in
his basic message of this chapter, which is that aggregating all
"capital" based on their price is basically nonsensical.
Except in a very narrow sense indeed, 10 books for $50 each and 2
computers for $1000 each is not $2500 of "stuff", and you
cannot calculate a rate of profit based on the value of the "stuff".
Prices vary as markets vary; you can’t take the price as some kind of
absolute measure of the good’s worth. Different capital goods are
used for different things, in different amounts, and depreciate at
different rates. The Cambridge
Capital Controversy
established all this… at which point neoclassicists simply ignored
this fact and went on aggregating capital in the same way.

Now, this might be an acceptable
simplification for some purposes; after all, there’s no way we could
possibly include every single type of good in our model. But you
should keep that in mind when you speak of a nation’s
"capital-to-labor ratio"; what does that mean exactly? If
it means anything at all, it’s clearly not about
price. A post-scarcity society in which everyone has automated
systems that provide them with anything they need is one in which the
marginal cost—and hence price—of all capital goods is
effectively zero. The price of labor might also be zero, or rather
labor decisions are not made on a wage basis; so do we count the
number of people who work, or what they are paid (nothing)? By price,
the capital-to-labor ratio would be 0/0, undefined; yet in a real
sense, it’s obvious that their capital-to-labor ratio is enormously
higher than ours. Conversely, if you are stranded in a desert and
someone offers to sell you a bottle of water for $1000 or a car for
$200,000, you’re spending an awful lot on capital and nothing on
labor; but we would not say that your capital-to-labor ratio is high.

Chapter 8 is my favorite chapter of
the book. Indeed, it could have been the entire book; most of the
rest seems superfluous. Chapter 8 is about assumptions and their role
in scientific theory. Keen distinguishes between three different
types of assumptions: negligibility assumptions, which are
safe (e.g. ignoring friction in plotting the trajectory of
spacecraft); heuristic assumptions, which are undesirable but
sometimes necessary (e.g. special relativity ignoring acceleration);
and domain assumptions, which are dangerous (e.g. neoclassical
economics assuming that markets are efficient). He thoroughly
demolishes Milton Friedman’s pseudoscientific argument that
"assumptions don’t matter" and "the more significant
the theory, the more unrealistic the assumptions".

Yes, this is where neoclassical
economics fails: its ludicrous assumptions that humans are rational,
information is perfect, externalities don’t exist, debt doesn’t
matter, prices adjust instantaneously, preferences are homothetic,
production has constant returns to scale, expectations are
rational… none of these assumptions are even remotely true, they
fundamentally alter the character of economic models, and often they
don’t even make the mathematics simpler. They merely serve to feed
the ideology that the free market is magic and government
intervention is evil.

Chapter 9 is about the difference
between statics and dynamics; it has always bothered me how
economists use "comparative statics" instead of actually
trying to work out dynamics. This is how you get things like "the
classical model" in which wages adjust to money supply changes
instantly and "the Keynesian model" in which they don’t
adjust at all. Obviously, wages do adjust to money supply changes,
but equally obviously it doesn’t happen immediately or all at once. A
dynamic model could very easily take this into account—dW/dt—but
comparative static models are forced to take an all-or-nothing
approach that produces ludicrous results either way.

Keen also uses this opportunity to
discuss complex systems and chaotic dynamics, which is also something
that is clearly desperately needed in economics. I think this is an
area I myself would do well to study more: I know very little about
the methods for solving complex nonlinear systems, and my first
thought would be to run huge computer simulations, which would
probably work but seems rather inelegant.

Chapter 10 is also a good one; it’s
about the greatest singular failing in the history of economics,
which is the failure of neoclassical economics to predict, prevent,
or even significantly mitigate the Second Depression. True, it wasn’t
as bad as the Great Depression, but back then economic science was
still quite new and computer simulations didn’t even exist. To make
the same fundamental mistakes 80 years later is simply unforgivable.

But of course they didn’t; the only
ones who got even close were the ones who are more sympathetic to
non-neoclassical theories, like Stiglitz and Krugman. Neoclassical
models predict smooth, efficient equilibrium; they simply can’t cope
with the idea of a sudden crash. And so, blinded by their own
ideology, neoclassicists didn’t believe a crash was possible even as
it had already begun. Honestly, the highest single priority of
macroeconomic theory should be to predict and prevent depressions,
shouldn’t it? But that is one thing that neoclassical economics is
simply incapable of doing.

Chapter 11 isn’t bad either; it’s
about financial markets, and how a massive system of everyone
second-guessing everyone else can lead to chaos and absurdity with no
foundation in the real world. This honestly is obvious to anyone who
looks (and it was obvious to Keynes), but somehow there are still
economists—a lot of them—who believe in the "efficient
market hypothesis".

Personally, I’m not sure the financial
markets as we know them should exist. Yes, we need savings and
checking accounts. Yes, we need loans to finance investment (new
factories, student loans) and large consumer purchases (houses,
cars). And… that’s about it, frankly. All these other layers of
finance really aren’t necessary as far as I can tell, and right now
what they do is sap wealth from everything else and make the whole
system more unstable. I really don’t see why we couldn’t have a fully
nationalized banking system that would perform only these basic
functions and nothing else. Nevada effectively has a nationalized
banking system, and not only is Nevada doing rather well, it actually
fared better in the crisis than any other US state. The basic
arguments for why free markets work (which are already limited) break
down almost completely for financial markets; there’s no comparative
advantage, no gains from trade, no mutual benefit; the whole system
is zero-sum and overwhelmed by asymmetric information. There are some
pretty good arguments for why auto manufacturing and computer
hardware are better off being privatized; but the fundamental basis
for those arguments breaks down completely when you try to apply it
to financial markets.

Alternatively, we could just regulate
much better, like in the Canadian system, which is almost universally
agreed to be the most stable and efficient banking system in the
world.

Chapter 12 is on the Great Depression.
Keen is absolutely right about two things: We need an empirically
validated theory of what causes depressions, and neoclassical
economics is not equipped to provide such a theory. Where he loses me
is on his particular Minsky-based theory of "debt deflation";
deflation was not a serious issue in 2009, and it is quite easy to
correct—raise minimum wage and print more money. Yes, the Great
Depression involved a lot of deflation, but that doesn’t seem to be
what caused the worst problems.

Debt, on the other hand, obviously is
important—but exactly how it causes depressions remains
unclear. Keen’s model proposes that aggregate demand is equal to GDP
plus the rate of change in debt; this doesn’t make much sense, since
GDP includes all spending on final goods—if that debt is being
spent on goods, it will already be counted. (And if it isn’t, what’s
it for?)

Chapter 13 is on Keen’s own
predictions of the Second Depression. I will give him credit where it
is due: He was one the first to predict the financial crisis, and did
so with precision and mathematical rigor. He didn’t just say "A
depression is coming"; he pointed to specific problems in the
housing market and the financial system.

Chapter 14 is Keen’s monetary model of
capitalism. Once again, Keen is absolutely right that we need
something like this—we need a comprehensive model of the
macroeconomy that includes monetary and financial systems. Our
current models are woefully inadequate—they massively
oversimplify money, and they typically don’t include debt at all. But
once again, Keen’s specific choice is less compelling; he bases it
around double-entry accounting with three sectors: Firms, consumers,
and bankers. It doesn’t seem completely wrong, but it’s also far from
complete. Still, it’s better than nothing—which is basically
what we have right now.

Chapter 15 is on the instability and
inefficiency in the stock market. Here is where chaos theory really
shines; if we are ever going to understand the dynamics of such a
complex system of feedbacks, it’s going to be using the tools of
chaos theory.

Right now, it’s mostly a sketch; it’s
certainly no comprehensive theory. But Keen freely admits this; he
more uses the chapter to express hopes for the future of chaos-based
economics, and also to demolish any vestiges of belief the reader
might have in the "efficient market hypothesis".

Chapter 16 is about mathematics, and
how it’s still vitally important, but must be used correctly. I
couldn’t agree more; one thing that never ceases to aggravate me is
people who try to argue that the basic methods of science, or math,
or even logic are flawed simply because they haven’t solved
some particular problem. Even worse is when they simply won’t accept
the solution—"Science has nothing to say about God!"
Yes, actually it does: It says he doesn’t exist.

Chapter 17 is about Marxism and why it
fails, particularly how the labor theory of value collapses.
Obviously the labor theory of value is dumb; something does not
become valuable simply because people have worked on it, and
something doesn’t stop being useful just because it was easy to make.

Yet Keen feels such a need to reject
neoclassical economics that he can’t even accept the utility theory
of value, even though it is obviously correct. Instead he tries to
come up with some alternative theory based on the supposedly
fundamental difference between use-value and exchange-value—when
that distinction has already been captured in the standard
distinction between utility versus price.

He mocks the neoclassical
theory as the "subjective theory of value", which is at
best a misleading way of putting it; the subjectivity involved is the
kind of "subjectivity" involved in saying that pain hurts
and orgasms feel good. It is the "subjectivity" involved in
saying that chairs are for sitting on and apples are for eating. One
could perhaps imagine a lifeform that felt differently, but we are
not that lifeform.

This is also something that moral
scientists have trouble explaining to everyone else: Morality is only
"subjective" in the sense that it depends on the
experiences of sentient beings. That doesn’t mean anything goes. It’s
not "rape is wrong if you think it is"; it’s "rape is
wrong because people don’t like being raped". Likewise, it is
objectively the case that goods have subjective value to
people, and that’s how our economy works.

Chapter 18 briefly summarizes some of
the alternative approaches: Austrian economics, evolutionary
economics, Post-Keynesian economics, Sraffian economics, and
econophysics. He rightly concludes that Austrian economics is a dead
end for the same reasons as neoclassical, and that Sraffian economics
doesn’t go far enough; but he is oddly skeptical of evolutionary
economics and econophysics, and gives more credit to
Post-Keynesianism than I think it really deserves. (Especially since
"Post-Keynesian" is a lot like "post-modern"; it
doesn’t describe what you’re doing so much as what you’re not doing
anymore.)

Oddly he does not include cognitive or
behavioral economics as one of the alternative approaches, even
though it plainly is. Indeed, he takes an oddly dismissive view of
cognitive economics, seeing us as apparently just working out a
series of ad hoc examples of minor irrationality that
ultimately will have no meaning for real-world economics.

And I suppose this is true, at least
of cognitive economics as currently practiced; but it is a field in
its infancy—it basically didn’t exist until about 15 years ago.
Give us a few more years, and you will see that it is a radical
paradigm shift as significant as evolutionary economics or
econophysics, and clearly far more so than Post-Keynesian or
Sraffian.

All the way throughout the book, Keen
seems intent on showing that neoclassical economics is wrong, wrong,
wrong, about everything, in every possible way. But
this was not necessary; reversed
stupidity
is not intelligence. Neoclassical economics does not get
everything wrong; in fact, it probably gets more things right
than the general folk notions most people have about economics. I
doubt most people realize that sales taxes create deadweight loss,
for example, or that the money supply is largely created by bank
loans and isn’t backed by any commodity; yet these are things that
neoclassicists definitely do understand quite well. Neoclassical
economics is wrong not at the core, but at the margins; but isn’t it
neoclassicists most of all who taught us that margins are everything?