PIET KEIZER ON THOMAS PIKETTY

Piet Keizer on Thomas Piketty

Introduction

This year Harvard University Press published the book by Thomas Piketty, titled “Capitalism in the Twenty-first Century. It appeared a hit. Many reactions, also from Paul Krugman, were very positive. Two important statements of the book are:

  1. The rate of return on capital is larger than the growth rate of output and income, which means the beginning of the end of capitalism.
  2. The introduction of a wealth tax, ideally on a global level, is a necessary step to save the system.

Today’s biggest problem is the significant increase of the wealth in the hands of the top 10%. Especially in the Anglo-Saxon world the increase has arisen sharply. Alas, Europe is going in the same direction. Piketty’s quantitative statements are based on an incredibly large database with respect to the distribution of income and wealth.  The data concern many countries and over very long periods; a true walhalla for econometricians.

His claim that inequality is the most important problem in the economy is not based on a careful analysis of the functioning of a capitalist economy; it is just based on a large series of ‘theory-free’ facts. This makes it necessary to critically assess the methodology behind Piketty’s claims.

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WHY NATIONS FAIL ACCORDING TO DARON ACEMOGLU

Why Nations Fail according to Daron Acemoglu

In 2012 Daron Acemoglu and James Robinson (AR) published a book titled Why Nations Fail. A large number of persons and organisations are recommending this book, among them 6 Nobel Laureates. The cover says that the book is shortlisted for the Financial Times and Goldman Sachs Business Book of the Year Award. Acemoglu is one of the honorary doctors of  the Utrecht University School of Economics. Reason enough to look at the book carefully.

The main thesis of the text says that institutions are critical to the wealth of a nation, and that geography, culture and expert advice are not. On the basis of an overwhelming amount of historical cases the authors claim that an extractive political institutional framework is the principal barrier for nations, which suffer from poverty for a long time. Institutions are extractive if the economic and political elite collude and use their power to extract as many resources from the nation as possible for their own objectives.

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FRANKFURT AND BRUSSELS, THE EURO ZONE MISINTERPRETED

Frankfurt and Brussels, The Euro Zone Misinterpreted

Introduction

Even after a crisis of more than six years, the European Central Bank (ECB) and the European Commission (EC) do not understand what’s going on in the Euro zone. The result is a wrong attitude towards Meditteranean countries, a bad monetary policy, and a terribly bad budget policy. In this short essay I will explain this misinterpretation, which makes that all policies with respect to the crisis appear ineffective. The reason why the overall economic performance in some countries, such as Germany and the Netherlands is not too bad, is that other regions in the world function well, thereby supporting the euro zone. A better understanding would lead to significantly better policy results.

Economic Research and Education

From the 80s on academic economic research and education in the Western world underwent an important transformation. In the first place, there is barely place for economic methodology and the methodological differences between the different schools of thought anymore. In the second place, most schools were excluded from the programmes, and the neoclassical analysis conquered a near-monopoly position. In the third place, the space for quantitative methods increased significantly. Research and education became increasingly dominated by empirical research without a carefully formulated theoretical foundation.

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Piet Keizer on Dan Ariely on Irrationality

Introduction

More than 50 years ago Herbert Simon criticised the neoclassical idea that the orthodox economic analysis, which is based on the assumption of the economic and rational homo oeconomicus, is a sound theoretical foundation for empirical research. Simon was a cognitive psychologist, and offered an alternative foundation, based on the assumption that cognitive capacities are limited. It means that in the process of decision-making people do not endlessly search for relevant information, but stop searching as soon as they have the idea that the marginal search benefits are not higher than the marginal search costs. In other words, they are satisfied with the information collected so far. It implies that actors are regularly making mistakes, and the question is whether people are inclined to make particular mistakes systematically.

Simon’s critique has had a very important influence on the way (business) economists approach the problem of decision-making. This approach is called behavioural economics, and even today there is not much methodological difference between Simon’s work and the way prestigious scientists in this field are operating now. There is, however a huge problem!! In this text I discuss the second edition of the book “Predictably Irrational” by Dan Ariely (2009), since this book is highly praised in prestigious circles.

Methodology

When Ariely was a psychology student, he assisted a professor neuro-science in his research on the effect of brain stimuli on human behaviour. He learned from his professor that science is an empirical endeavour. When Ariely began his own research he designed many experiments to show to economists that human persons are predictably irrational. He used the orthodox-neoclassical model as his point of reference. Unfortunately he does not explicitly formulate this model – actually he compares the results of his experiments with his (economic) intuition. Experiments show that the choices are systematically different from what is economically expected.

If Ariely would have formulated the orthodox-economic analysis explicitly, he could have seen that the model results from introspection, and is based on the economic motive only. In other words, they recognise just the economic motive as driver, and ignore the psychic and the social drive on purpose. When doing experimental and empirical research we ought to develop a psychological and a sociological analysis first, and integrate them with the economic model. Now his psychology is one without a psyche, and sociology does not even exist! We will discuss two experiments to show the misinterpretations that result from a lack of a multidisciplinary economic analysis.

Experiments

The first experiment shows a situation, in which a person is at the point of buying a pencil with a price of $14. Then a fellow customer whispers in his ear that in another shop the price of exactly the same pencil is $7.The shop is on a 15 minutes-walk distance. It appears that most persons decide to go to the cheaper shop. In another situation a customer is at the point of buying a suit for $488. Again a whisperer tells him that exactly the same suit can be bought for $481 in a shop on a 15 minutes-distance walk. Just a small minority takes the walk and buys the cheaper copy. Ariely explains this result in terms of a cognitive failure: people tend to calculate in terms of percentages, even when absolute numbers is the rational use of our cognitive capacities. When interpreting the result in a more realistic way we must acknowledge that humans are driven by more motives than just the economic one. When the other motives are ignored the interpretation of experiments and empirical research is necessarily flawed.

When I asked myself and a couple of friends to give their answer plus motivation to the questions concerning the purchase of the pencil and the suit, completely different interpretations appeared. One person said that the price difference in case of the pencil might reflect an abnormal profit margin – “I don’t want to support this behaviour”. Another person said that in the case of the  suit you never know for sure that the quality is similar – “I don’t to go up and down the street to find out what is the best suit for just $7”. A third person’s choice, which was in line with the choice of the majority of the persons, who participated in the experiment by Ariely, and she motivated it as follows. If I waste an amount of $7 for a purchase of $14 already, than I’m not optimising my allocation of scarce resources. But a waste of the same amount in case of a purchase of several hundreds of dollars – that’s  not so bad. We see that the last person has apparently developed a rule, which says that he should be more cautious in case of cheap goods – you buy them so often! Penny wise does not necessarily mean pound foolish. [this idea of waste is quite similar to the so-called X-inefficiency rule of Harvey Leibenstein(1966)].

A second experiment is about an employer and an employee. The salary is $100.000 per year and the employee is happy with it. Then he discovers that his colleague, who is perfectly identical to her in terms of education, experience and performance earns a salary of $120.000. The outcome of the experiment shows that most employees go to their boss and ask for explanation. Ariely interprets this behaviour as irrational, which is a cognitive failure as we saw. When we apply a multidisciplinary economic analysis of the situation, however, we interpret this behaviour as socially motivated. In Europe the action of the employee would be interpreted as justified and in line with the generally accepted norm ‘equal pay for equal output’. According to European cultural standards the employer discriminates. He might be a sexist, a racist or a nationalist; in that case he is rational according to his own standards. But according to European standards he is immoral. To call the behaviour  of the employee irrational is completely beside the point.

Lessons

Empirical research can only be conducted by researchers who dispose of a sophisticated multidisciplinary economic analysis of the situation under scrutiny. So with experimental research. Even if we want to collect empirical data – by means of a questionnaire, for instance – we need such a theoretical foundation. The book by Ariely – extremely popular in the Anglo-Saxon world – illustrates why so much empirical and experimental work is still premature. Gamma-scientists should focus their attention to significant improvements of the theoretical foundation, so as to make it more realistic. Theory-free interpretations make no sense.

Dr. Piet Keizer

Utrecht University School of Economics

p.k.keizer@uu.nl

www.pietkeizer.nl

12-02-2014

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DAVID ROTHKOPF ABOUT THE GLOBAL POWER ELITE

David Rothkopf about the global power elites (02-06-2014)

  • Introduction

In his book “Superclass. The global power elite and the world they are making” (2008) Rothkopf offers an insider’s view on the various power elites, which have a significant effect on the evolution of global society. An important finding is that elites do hardly conspire. Their influence is the result of the development of a common view on the world. By regular meeting each other members of the ‘club’ learn how they must interpret particular developments, and who is to be trusted.

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MENGER ON EXACT LAWS VERSUS EMPIRICAL LAWS

Menger on Exact Laws versus Empirical Laws (19-02-2014)

In his Investigations into the Method of the Social Sciences With Special Reference to Economics (1883) Menger takes position in the Methodenstreit between the deductivism and inductivism. Menger advocated the deductivist approach and saw the formulation of exact laws as a necessary element in the development of reliable knowledge. According to him exact theory is based on a few axioms. There are universal categories, such as ‘economic’ and ‘rational’, and exact laws are describing the interrelationship between the essences of these categories or concepts; essences which are formulated in definitions of a particular object. So, exact laws are propositions expressing universal connections among essences. Our reality as we experience it permanently, is about properties and can change continuously. When an object is defined we can observe its properties. Without systems of definiitons empirical researchers are blind.

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THE EUROPEAN ECONOMIC CRISIS AND THE CRISIS IN ECONOMICS (II)

The European Economic Crisis and the Crisis in Economics (II) (06-08-2013)

Introduction

In the first part of this essay we have discussed the European economic crisis and stated that the almost complete disappearance of genuine macroeconomics from the educational and research programmes in the North Western world has led to a large-scale cognitive closure among the leading economists. They did not foresee the crisis, while heterodox economists explained in detail the crisis yet to come. In this second part I will show that also the discussion about the necessary reforms suffers from a lack of realistic economic analysis. Institutions are rules of behaviour, applied by persons and organisations. Examples of institutions are habits, routines, customs, and moral and legal rules. According to the neoclassical philosophy institutions are meant to channel behaviour of economic, rational and non-social actors, such that their economic efficiency improves. Rules have the capacity to limit and to enable particular activities. If a legal rule says that discrimination is forbidden, and employers obey this rule, room is created for potentially discriminated people to employ profitable activities. Neoclassical analysis says that the world consists of competitive markets, and discriminative behaviour, by leaving profitable opportunities unused, cannot survive. So anti-discrimination legislation is actually superfluous. But if we assume that actors are also social beings, who are solidary within their own group and are rivalling with members of other groups, anti-discrimination rules might be economically efficient. Governments should only set rules in case of public goods, and there are just a few of this type!

Actual European Economic Institutions

This view on institutions is well-understood by economists – it fits their neoclassical intuition.  Actual economic European institutions are not built on a neoclassical view on economy, however. Collective bargaining and social security arrangements, are meant to improve the efficiency of labour markets and of society as a whole. In heterodox economics, economic sociology and behavioural economics the neoclassical paradigm of the economic and rational actor is criticised. Neoclassical economists use an analysis of the economic aspect of human behaviour to explain real life phenomena. But there are two other primary human motivations, which are the social and the psychic motivation. The social motivation concerns the drive to form homogeneous groups and to maximise the status of the own group relative to that of relevant other groups. The psychic motivation concerns the drive to maximise self-respect, by protecting particular interpretations of world and self, right or wrong, for instance. If we combine the three primary motivations in an integrated micro paradigm, and develop a realistic macro paradigm in terms of a historically evolving whole of open subsystems, the analysis of economy and society will be very different from what students are taught at the moment.  economics becomes more scientific, and results in better understanding, followed by meaningful and effective action.

Control Mechanisms

With respect to an understanding of the institutional framework of economies, the necessary revolution in economics would lead to a more sophisticated analysis. Then  institutions should channel three types of motivation, in such a way that resources are allocated efficiently. Economic, psychic and social goals should be achieved within acceptable restrictions. Progress also means that people become increasingly rational and positive-social. When we interpret institutions as control mechanisms, we can distinguish personal control, social control, economic control and political control. Economies and societies need all these mechanisms to maintain an acceptable degree of reasonability. If persons, especially those who have the power to take important decisions, are out of control – they are irrational – social control might lead to necessary corrections. If personal and social control mechanisms do not function well, economic control mechanisms might work and correct the mistakes, which are made. The problem, however, is that lack of personal and social control might hamper  economic control mechanisms. Too much credit to spenders and a fatal expansionary monetary policy is the result. Moreover, if irrational subcultures, in which personal and social control mechanisms are out of order, dominate governance and control agencies, political control  turn out to be very ineffective.  It seems that the economic crisis is caused by a psychological and cultural trend in our permissive society, in which the various mechanisms of control appear increasingly dysfunctional. It has made the various subsystems more fragile, which means that small negative events, can have far-reaching consequences.

Economic Instabilities in Post-War Europe

After WW II we experienced a long period of stable economic growth. During the sixties left-orientated politicians and macro-sociologists became overoptimistic about the possibility of building a huge welfare state alongside a large market sector. During the seventies we discovered that these expectations were irrational. During the eighties, however, classical-liberal politicians and neoclassical economists became overoptimistic about the possibility of a free-market economy, without any control mechanism. Competition would lead to the survival of economic and rational persons and organisations. Governments were supposed to have the possibility to maintain competition on an acceptable level. Economic sociologists warned for the influence of powerful firms on the government agencies, which should maintain competitiveness. But their discipline have never become part of the obligatory educational programmes of economists. Psychological (behavioural) economists warned for irrational action of persons and organisations. But their contributions have not reached the economic textbooks about markets and market economies. The long period of over-optimism – from the eighties until the financial crisis 2008 – coincide with a strong classical liberal focus on individual freedom. It has led to a dismantling of control mechanisms. The financial world lobbied successfully for deregulation. Leading persons in the business sector became more narcistic and began to take huge risks with respect to mergers and acquisitions, for instance.  Subcultures grew, in which persons became increasingly reluctant to be critical towards colleagues – based on a fear to lose their effectiveness, so to speak. Economic control mechanisms became increasingly ineffective. In earlier times many primary banks were socially responsible organisations, serving the interest of their clients. But in the liberal era they tried to maximise their profits by making intransparant products. They lobbied successfully for a relaxed monetary policy – the responsibility of the so-called independent central bank. It made possible for many banks and other organisations, to finance real estate and financial assets by means of bank credit.

Towards a more Scientific and Pluralistic Economics

When we look at the educational programmes we see that economic science is not presented as a rich science with a long tradition of competition and cooperation between different paradigms. The scientific character has eroded, and empirical research without a realistic paradigm and analysis dominates the scene. Economics students should – straight from the beginning – being confronted with a number of essentials, such as an explicit formulation of the neoclassical paradigm, including a careful definition of concepts such as economic, psychic and social (1), neoclassical analysis as the modelling of only one aspect of human behaviour (2), real life economic phenomena result from multi-motivated action(3), serious attention to heterodox economics, and psychology and sociology as far as relevant for economists (4), and a first introduction into philosophy of science – also in a pluralistic way (5). Only in this way it might be possible to reduce prejudice and the continuing rivalry between different schools of thought. To prevent such cognitive closures as we face now might be an important contribution to reduce the severity of the next crisis.

 

Dr. Piet Keizer

Associate Professor Economic Methodology

Utrecht University School of Economics

http://www.pietkeizer.com

1214 words

06-08-2013

 

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THE EUROPEAN ECONOMIC CRISIS AND THE CRISIS IN ECONOMICS (1)

The European Economic Crisis and the Crisis in Economics (I) (06-08-2013)

Introduction

In 2008 the American financial crisis created a serious credit crunch in the Western world, followed by a global depression in 2009. China and the USA stimulated their economies, and were able to recover quickly. Brussels, however, began to blame the national governments for their debt ratio’s  being too high. Leading economists, especially in Germany and The Netherlands, saw the welfare state as the bottleneck for the free-market economy to flourish. They advocated government expenditure cuts and institutional labour market reform. Unfortunately this typical neoclassical policy has not achieved its goal of budget deficit reduction, and prolonged the depression. Over the years we see a growing debate between the hawks and the doves within the group of neoclassical economists. The hawks advocate increasing government expenditure cuts, while the doves  plea for less budgetary discipline, as long as the economy is in a recession (even now spenders are economically depressed, they call the situation still depressed!) . How come that European economists are doing such a bad job when advising their governments? In this essay I suggest that the neoclassical dominance on the ‘market’ of economic ideas has created a cognitive closure among leading economists, which leads to consistently biased policy advice.

Education at Economics Faculties

Until WW II programmes of education and research at Economics Faculties were more pluralistic, and students were taught that economic problems could be approached from different points of view. From then on the dominance of the neoclassical approach has increased, and has established an almost-monopoly. Especially the increasing use of quantitative methods on the basis of a biased theoretical foundation, has led to a reduction of economic science to a set of technical and quantitative problems.

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