Ken Arrow and financial weapons of mass destruction

Why do Economists believe that Economics is a real subject, like Physics, rather than a type of pedagogy for the second rate- like 'Literary Theory' for those who struggle to read, or 'Creative Writing' for those with little imagination and no innate talent?

Consider the opening to Ken Arrow's Nobel lecture-

 From the time of Adam Smith’s Wealth of Nations in 1776, one recurrent theme of economic analysis has been the remarkable degree of coherence among the vast numbers of individual and seemingly separate decisions about the buying and selling of commodities.

If you have something you want to swap for something else you might try standing outside your house with it and accosting strangers. They will tell you to take your shit down to the Town Square or other such 'Schelling focal' solution to the coordination problem. You go around the market a couple of times and you get an idea as to what is the 'going rate' for different commodities. 

Economic analysis has to be pretty fucking retarded if it makes a big deal out of this obvious piece of common sense. If you want to buy or sell gold, go where 'Goldsmith's street'. If you want to buy or sell cotton, go to the Cotton Exchange. This stuff aint rocket science.  

In everyday, normal experience, there is something of a balance between the amounts of goods and services that some individuals want to supply and the amounts that other, different individuals want to sell.

No. In everyday, normal experience, your brother-in-law, bum that he is, remains an unemployed layabout even though he went to Cornell. Whatever it is he is selling, nobody's is buying.  

Would-be buyers ordinarily count correctly on being able to carry out their intentions, and would-be sellers do not ordinarily find themselves producing great amounts of goods that they cannot sell. This experience of balance is indeed so widespread that it raises no intellectual disquiet among laymen; they take it so much for granted that they are not disposed to understand the mechanism by which it occurs.

Laymen? Is Economics an esoteric discipline which grants its priesthood the power to loose and bind? Is it based on Heavenly revelation? Do its practitioners perform miracles or cast out demons?

If not, why make any such distinction?

Now it is true that Physicists and Chemists and Medical Doctors are able to do some things which the uninstructed are not. However, nothing similar holds with respect to Economics or Literary Theory or Sociology or Political Philosophy

The paradoxical result is that they have no idea of the system’s strength and are unwilling to trust it in any considerable departure from normal conditions. This reaction is most conspicuous in wartime situations with radical shifts in demand. It is taken for granted that these can be met only by price control, rationing, and direct allocation of resources.

These were methods advocated by some economists at that time. Other economists may have made different suggestions. But this was also true of lawyers and politicians and so forth.

There is no evidence that Economists ever had a consensus on a matter on which 'laypeople' were wrong. There is no Galileo for Economics. On the contrary, all there has been is competing Inquisitions on the one hand and agnostics on the other.

Yet there is no reason to believe that the same forces that work in peacetime would not produce a working system in time of war or other considerable shifts in demand.

Arrow is being silly. If you have conscription, those who remain behind aren't going to be allowed to profiteer too visibly. Otherwise, you get a Bolshevik revolution.

(There are undesirable consequences of a free market system, but sheer unworkability is not one of them.)

This is nonsense. The free market system is wholly unworkable if crime is unchecked or an invading army is not opposed.

I do not want to overstate the case. The balancing of supply and demand is far from perfect. Most conspicuously, the history of the capitalist system has been marked by recurring periods in which the supply of available labor and of productive equipment available for the production of goods has been in excess of their utilization, sometimes, as in the 1930’s, by very considerable magnitudes.

So what? Any Society may end up with too much of something or too little of something else. Expectations are often proven wrong. Suppose it is discovered that a meteor is going to hit the earth. It is likely that a lot of our Capital investment decisions were wrong headed. The same is true if we believed a Revolution of a certain sort was likely, but it did not in fact come to pass.

Laypeople understand this very well. Myopic mathematical economists may remain incorrigible in these matters. Alternatively, they might simply play with their toys during work-hours and be sensible the rest of the time.

Further, the relative balance of overall supply and demand in the postwar period in the United States and Europe is in good measure the result of deliberate governmental policies, not an automatic tendency of the market to balance.

This has always been true. People like Keynes pretended, in the Thirties, that stupid Economists had caused the Depression. That is why Keynes said his 'General Theory' was addressed to his colleagues. Laymen were welcome to listen but should keep their mouth shut.

However, Economists didn't cause the Depression. Why? They were shite. They had no power. Most were poor and taught in cow colleges. The one or two who made money on the Stock Market- people like Irving Fischer- remained bullish on fundamentals and were thus revealed to be shitheads.

Nevertheless, when all due allowances are made, the coherence of individual economic decisions is remarkable.

To whom? Only a guy who thinks it miraculous people don't shit their pants all the time.

As incomes rise and demands shift, for example, from food to clothing and housing, the labor force and productive facilitities follow suit.

As one begins turtling one goes into the toilet and lowers one's trousers. Isn't that extraordinary? How do people know a great big turd is going to emerge from their anus?

Similarly, and even more surprising to the layman, there is a mutual interaction between shifts in technology and the allocation of the labor force.

How stupid did Arrow think people who had studied Engineering or Law instead of Econ actually were? Even Chomsky didn't write an outraged article about telegram delivery people losing their jobs because of neo-liberalism.

As technology improves exogenously, through innovations, the labor made redundant does not become permanently unemployed, but finds its place in the economy.

Arrow is being silly. Some older people will never get another job. Many will never get quite as good a job. There will be localized effects on property prices and small business profitability. Laypeople understand this. Only real smart Economists can't.

It is truly amazing that the lessons of both theory and over a century of history are still so misunderstood.

By economists, not laypeople.

On the other hand, a growing accumulation of instruments of production raises real wages and in turn induces a rise in the prices of labor-intensive commodities relative to those which use little labor. All these phenomena show that by and large and in the long view of history, the economic system adjusts with a considerable degree of smoothness and indeed of rationality to changes in the fundamental facts within which it operates.

So Economists aren't really needed- save perhaps to serve a pedagogic function or else as political window dressing.

The problematic nature of economic coordination is most obvious in a free enterprise economy but might seem of lesser moment in a socialist or planned society.

WTF?! The thing is seamless under free enterprise. It is problematic in a command economy coz the thing involves all sorts of administrative protocols and bureaucratic procedures.

But a little reflection on the production and consumption decisions of such a society, at least in the modern world of complex production, shows that in the most basic aspects the problem of coordination is not removed by the transition to socialism or to any other form of planning.

Wow! Arrow said this in 1972. Talk about being on the wrong side of History!

In the pure model of a free enterprise world, an individual, whether consumer or producer, is the locus both of interests or tastes and of information. Each individual has his own desires, which he is expected to pursue within the constraints imposed by the economic mechanism; but in addition he is supposed to have more information about himself or at least about a particular sphere of productive and consumptive activity than other individuals. It might be that in an ideal socialist economy, all individuals will act in accord with some agreed ideas of the common good, though I personally find this concept neither realistic nor desirable, in that it denies the fact and value of individual diversity. But not even the most ideal socialist society will obviate the diversity of information about productive methods that must obtain simply because the acquisition of information is costly. Hence, the need for coordination, for some means of seeing that plans of diverse agents have balanced totals, remains. How this coordination takes place has been a central preoccupation of economic theory since Adam Smith and received a reasonably clear answer in the 1870’s with the work of Jevons, Menger, and above all, Leon Walras: it was the fact that all agents in the economy faced the same set of prices that provided the common flow of information needed to coordinate the system.

Smith, Jevons, Menger, Walras et al did not ask how coordination problems are solved. That was Thomas Schelling's contribution. Rather those old geezers assumed markets were focal and the solution occurred there- maybe through a Walrasian autioneer or some such theoretical apparatus.

Price vectors aren't what people coordinate on the basis of. Rather it is their own Expected Cost or Benefit which determine which focal point for coordination they choose. Vendors can change what is focal. So can Buyers. Any focal point can be thought of as a market and the reverse is also true. Thus we speak of a University as 'a market place of ideas', or a singles bar as a 'meat market'- because some sort of transaction or exchange occurs there. Exchanges don't have to all occur, or have to occur in a time irreversible fashion, at these focal points. Pareto efficiency can be achieved elsewhere and in a manner such that both parties can unwind sub-optimal transactions. Thus a 'price vector' is merely a public signal, one among many, associated with a focal point. Correlated equilibria can evolve independently from there in different directions.

Arrow's believes he has incorporated Uncertainty in his model. Actually, he has only incorporated probability.

We take from the theory of probability the concept of a state of the world, which is a description of the world so precise that it completely defines all initial holdings of goods and all technological possibilities. Uncertainty is not knowing which state will in fact hold...

 Commodities in the ordinary sense are replaced by contingent commodities, promises to buy or sell a given commodity if and only if a certain state of the world occurs. The market will then determine contingent prices. Clearing of the markets means clearing of the contingent markets; the commitments made are sufficiently flexible so that they can always be satisfied.

Aristotle had warned of the danger of greater precision (akrebia) then the subject matter warrants. Economics does not warrant a 'description of the world so precise' that it could never be computed in the lifetime of, not just the species, but the Universe itself.

Speaking of Aristotle, the further question arises, why should Economics confine itself only to monetary exchanges? One may speak of non-monetary transactions- e.g. relationships of give and take- as contingent contracts of Arrow's sort. What these don't cover is radical, Knightian, Uncertainty where possible states of the world are unknown. Consider what happens when you and I have a good faith contingent contract. However, for an unanticipated reason, I can't make good. Then, though a price existed and 'supply' and 'demand' seemed to match, actually there was no supply in one particular case and thus there was excess demand. No doubt, this risk could be insured against. However, the same problem arises. What if the insurance policy can't pay out? We could then have reinsurance and re-reinsurance and so on...an infinite regress of insurance.

 However, the problem would not go away. If we can't anticipate all future states of the world and assess their probability then excess demand is bound to arise because supply fails under an unanticipated contingency- including the possibility that probability was miscalculated. In the short to medium term, this may not be known. But sooner or later, the tide goes out and a lot of people are discovered to have been swimming naked.

To say-

The general equilibrium of the economy is then the set of prices which equate all excess demands to zero

is to say 'the general equilibrium of the economy is where every contingent contract is knowably fulfillable- i.e. all possible future states of the world are known and their likelihood is common knowledge.

However, if this were the case, there would be no need for markets or prices or, indeed, for communication. Our perfect foreknowledge would cause us to, like windowless monads, synchronize our actions perfectly. We would wake up in the morning knowing exactly from which individuals we should take the various things we need and exactly to whom to give the things we would otherwise sell. No words need be exchanged. Language would be redundant. No education would be needed. Everything would be common knowledge. There would be no need for the Law or the Insurance industry. Everything would be known in advance.

Arrow, unlike Sen, was a first rate economist. His notion of contingent contracts is used by the Fintech industry.

 Clearly, the contingent commodities called for do not exist to the extent required, but the variety of securities available on modern markets serves as a partial substitute. In my own thinking, the model of general equilibrium under uncertainty is as much a normative ideal as an empirical description. It is the way the actual world differs from the criteria of the model which suggests social policy to improve the efficiency with which risk-bearing is allocated.

This 'normative ideal', prior to the financial crisis, led to excessive securitization and a hypertrophy of the derivatives market. Warren Buffet, or so it is believed, warned of 'financial weapons of mass destruction'. No doubt, post-crash fears were exaggerated. The US stock market index has quadrupled since then. Still, it is evident that the 'markets for everything' approach is no panacea. Arrow did not hit the mark. His hamartia was the hubris that precipitated the sub-prime Crash.