Why everything we know about modern economics is wrong
from Lars Syll
The proposition is about as outlandish as it sounds: Everything we know about modern economics is wrong. And the man who says he can prove it doesn’t have a degree in economics. But Ole Peters is no ordinary crank. A physicist by training, his theory draws on research done in close collaboration with the late Nobel laureate Murray Gell-Mann, father of the quark …
His beef is that all too often, economic models assume something called “ergodicity.” That is, the average of all possible outcomes of a given situation informs how any one person might experience it. But that’s often not the case, which Peters says renders much of the field’s predictions irrelevant in real life. In those instances, his solution is to borrow math commonly used in thermodynamics to model outcomes using the correct average …
If Peters is right — and it’s a pretty ginormous if — the consequences are hard to overstate. Simply put, his “fix” would upend three centuries of economic thought, and reshape our understanding of the field as well as everything it touches …
Peters asserts his methods will free economics from thinking in terms of expected values over non-existent parallel universes and focus on how people make decisions in this one. His theory will also eliminate the need for the increasingly elaborate “fudges” economists use to explain away the inconsistencies between their models and reality.
Ole Peters’ fundamental critique of (mainstream) economics involves arguments about ergodicity and the all-important difference between time averages and ensemble averages. These are difficult concepts that many students of economics have problems with understanding. So let me just try to explain the meaning of these concepts by means of a couple of simple examples.
Let’s say you’re offered a gamble where on a roll of a fair die you will get €10 billion if you roll a six, and pay me €1 billion if you roll any other number.
Would you accept the gamble?
If you’re an economics student you probably would because that’s what you’re taught to be the only thing consistent with being rational. You would arrest the arrow of time by imagining six different ‘parallel universes’ where the independent outcomes are the numbers from one to six, and then weight them using their stochastic probability distribution. Calculating the expected value of the gamble — the ensemble average — by averaging on all these weighted outcomes you would actually be a moron if you didn’t take the gamble (the expected value of the gamble being 5/6*€0 + 1/6*€10 billion = €1.67 billion)
If you’re not an economist you would probably trust your common sense and decline the offer, knowing that a large risk of bankrupting one’s economy is not a very rosy perspective for the future. Since you can’t really arrest or reverse the arrow of time, you know that once you have lost the €1 billion, it’s all over. The large likelihood that you go bust weights heavier than the 17% chance of you becoming enormously rich. By computing the time average — imagining one real universe where the six different but dependent outcomes occur consecutively — we would soon be aware of our assets disappearing, and a fortiori that it would be irrational to accept the gamble.
From a mathematical point of view, you can (somewhat non-rigorously) describe the difference between ensemble averages and time averages as a difference between arithmetic averages and geometric averages. Tossing a fair coin and gaining 20% on the stake (S) if winning (heads) and having to pay 20% on the stake (S) if losing (tails), the arithmetic average of the return on the stake, assuming the outcomes of the coin-toss being independent, would be [(0.5*1.2S + 0.5*0.8S) – S)/S] = 0%. If considering the two outcomes of the toss not being independent, the relevant time average would be a geometric average return of squareroot [(1.2S *0.8S)]/S – 1 = -2%.
Why is the difference between ensemble and time averages of such importance in economics? Well, basically, because when assuming the processes to be ergodic, ensemble and time averages are identical.
Assume we have a market with an asset priced at €100. Then imagine the price first goes up by 50% and then later falls by 50%. The ensemble average for this asset would be €100 – because we here envision two parallel universes (markets) where the asset-price falls in one universe (market) with 50% to €50, and in another universe (market) it goes up with 50% to €150, giving an average of 100 € ((150+50)/2). The time average for this asset would be 75 € – because we here envision one universe (market) where the asset price first rises by 50% to €150 and then falls by 50% to €75 (0.5*150).
From the ensemble perspective nothing really, on average, happens. From the time perspective lots of things really, on average, happen. Assuming ergodicity there would have been no difference at all.
On a more economic-theoretical level, the difference between ensemble and time averages also highlights the problems concerning the neoclassical theory of expected utility that I have raised before (e. g. here).
When applied to the mainstream theory of expected utility, one thinks in terms of ‘parallel universe’ and asks what is the expected return of an investment, calculated as an average over the ‘parallel universe’? In our coin tossing example, it is as if one supposes that various ‘I’ are tossing a coin and that the loss of many of them will be offset by the huge profits one of these ‘I’ does. But this ensemble average does not work for an individual, for whom a time average better reflects the experience made in the ‘non-parallel universe’ in which we live.
Time averages give a more realistic answer, where one thinks in terms of the only universe we actually live in and ask what is the expected return of an investment, calculated as an average over time.
Since we cannot go back in time – entropy and the arrow of time make this impossible – and the bankruptcy option is always at hand (extreme events and ‘black swans’ are always possible) we have nothing to gain from thinking in terms of ensembles.
Actual events follow a fixed pattern of time, where events are often linked to a multiplicative process (as e. g. investment returns with ‘compound interest’) which is basically non-ergodic.
Instead of arbitrarily assuming that people have a certain type of utility function – as in the neoclassical theory – time average considerations show that we can obtain a less arbitrary and more accurate picture of real people’s decisions and actions by basically assuming that time is irreversible. When our assets are gone, they are gone. The fact that in a parallel universe they could conceivably have been refilled, is of little comfort to those who live in the one and only possible world that we call the real world.
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—— Ugarteche, Puyana and Madi ——
Gerson Lima / Maria Alejandra Madi
Edward Fullbrook and Jamie Morgan
————— Michael Hudson ————–
Maria Alejandra Madi / Jack Reardon
————- Edward Fullbrook ————-
—————— Steve Keen —————–
————— Richard Smith —————
————– Gustavo Marques————
– Victor Beker and Beniamino Moro –
————– Lars Pålsson Syll ————-
—————– Stuart Birks —————-
Edward Fullbrook and Jamie Morgan
———— Armando Ochangco ———-
Shimshon Bichler / Jonathan Nitzan
————— Mauro Gallegati ————–
————— Herman Daly —————-
————— Asad Zaman —————
—————– C. T. Kurien —————
————— Robert Locke —————-
Ah, entropy, yes.
Dear Lars Syll,
I guess the problem with economics is much deeper than you imply. Although far-reaching your argument is. It is the whole method borrowed from Newtonian physics used to understand economics which has to be questioned. I just did so in my recently published article in PAER http://www.paecon.net/PAEReview/issue94/Stahel94.pdf I invite you to have a look at it and would love to hear your critique/comments on it.
Sincerely yours,
andri
Andri, mainstream economics did not properly borrow Newtonian method, because it only took the deductive part. Thus it neglected the non-rational inference of possible hypotheses from observations and the comparison of deductions with more observations. Neoclassical economics is not science, it is mathematical pseudo-science.
However it is true that a *reductionist* approach works brilliantly for the non-living world and hopelessly for the living world. A mouse reduced to its component parts is not a mouse, it is dead. One must study the whole mouse. One must study a whole society and its embedded economy.
Often told physics envy is a distorted picture of modern economics. If economics really tried to imitate modern physics, it would have not adopted equilibrium framework. Statics is a part of modern physics but its major contents were already discovered in the Alexandrian period, by Archimedes for example. Even if some economists tried to introduce modern physics, we should always note that it was a failed attempt as Geoff Davies points it out.
Typo in third sentence of third paragraph. Think that you mean weighs not weights.
Every fund manager is e aware that losing 50 per cent and then gaining 50 per cent leaves you 25 per cent worse off. The way this is handled in practice is to pay careful attention to bet size in relation to the size of your total portfolio or endowment. To take Lars’ example, if you are really confident that the market is offering 10 to 1 on a 6 to 1 shot you would always take it – but for small money, such that you could afford to make the bet often enough to finish ahead. You would never bet a billion dollars on anything, however likely it seemed, unless in Greenspan’s words you were “desirous of losing money”. Bet sizing is known to all traders to be the most important element in any trading strategy. That is “rational” behaviour and would not be condemned by any economist, even a neoclassical one.
The examples seem consistent with traditional economics if one introduces risk aversion into the utility function, so utility is maximized, not expected value. Is that all there is to this?
My son is a stock market investor and uses the Kelly betting method as part of his investment strategy moves. This equates, as I understand it, to what Gerald Holtham is saying. With all due respect to Ole Peters he may be attacking a straw man. A student of Economics 101 may make the mistake exemplified but not a fund manager as Gerald Holtham points out. However, doesn’t this argument simply indicate that Ole Peters’ critique is related to financial economics and not to the entirety of economics? A better way to refute the entirety of conventional economics is the path opened up by Bichler, Nitzan, Fix et.al, over at the “Capital as Power” site.
Blair Fix’s “Aggregation” paper, linked to below, points out the dimensions (literally) of the aggregation problem in conventional economics with respect to the ecological sustainability and biophysical issues of the real economy.
Those issues are special cases of the general case of opportunity cost. Conventional economics’ claim to deal with scarcity (to make efficient use of scarce resources) also fails upon a full consideration of the aggregation problem. These considerations actually amount to a comprehensive scientific refutation of the entire foundations of conventional (classical and neoclassical) economics.
I like to suggest that people read Fix’s paper and then ponder why I make the claims above. How is the aggregation issue linked to (and refuting of) applied opportunity cost reasoning and applied scarcity reasoning, in the money metric, in conventional macro economics? If you figure that out, you will fully understand, I believe, why conventional economics and the system it advocates and supports, capitalism, cannot succeed in dealing with global problems like limits to growth, ecological unsustainability, scarcity and inequality. Fail to explore these questions and we remain mired in the ideological and “numéraire-metric” ontological falsehoods of conventional economics.
Of course, the credit for these insights belongs to Bichler, Nitzan, Fix et.al. I am just the self-appointed messenger.
Or, without engaging in obscure theory, you can just notice there are instabilities all around (financial booms and crashes, runaway concentration of wealth, runaway growth of dominant firms, …) and conclude that an equilibrium theory is completely inappropriate.
Geoff is right. We should “concluded that an equilibrium theory is completely inappropriate” in economics. But pointing it is a taboo because many heterodox economists employ equilibrium frameworks as their main method of analysis. I am saying the same thing by expressing that “Equilibrium is an epistemological obstruct.” See my posts in the following threads:
My comment on November 26, 2020 at 2:40 am
https://rwer.wordpress.com/2020/11/26/a-valid-ontology-for-economics/
My comment on October 14, 2020 at 3:09 pm in
https://rwer.wordpress.com/2020/10/09/modern-macroeconomics-theory-based-on-misleading-illusions/
There was a long series of arguments on Asad Zaman’s article Complexity Economics posted on December 4, 2020 and it still continues.
I have talked about equilibrium but also about complexity and its meanings for economics. Please see for example following three “Replies”:
https://rwer.wordpress.com/2020/12/04/complexity-economics/#comment-175793
https://rwer.wordpress.com/2020/12/04/complexity-economics/#comment-176016
https://rwer.wordpress.com/2020/12/04/complexity-economics/#comment-176160
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Davis & Hands make an important distinction between complexity thinking that trivializes intractability and complexity thinking that takes intractable problems seriously.
I thought of you when I read this quote from “Economy, Society, Nature: An introduction to the new systems-based, life-friendly economics (World Economics Association Books)” by Geoff Davies –
“The third revolution is the revolution of systems science that has given us the radically new (for science) appreciation of self-organisation, complexity and chaos. Its lesson is that some systems cannot be reduced to their component parts but must be studied as a whole. Some systems’ behaviour is emergent, and only manifests when the system is fully functioning. Such systems must be studied holistically. Furthermore many such systems are not predictable in the detail of their behaviour. It is apparent that living systems especially must be studied holistically, and with the humility to acknowledge that not every detail of their behaviour will be predictable.”
Start reading this book for free: https://a.co/aFo1h5k
I thought of you when I read this quote from “Economy, Society, Nature: An introduction to the new systems-based, life-friendly economics (World Economics Association Books)” by Geoff Davies –
“How to study economies scientifically The process of understanding economies can proceed by the following steps. 1. Observe the economy and look for patterns in its behaviour. 2. Attempt to describe a perceived pattern. The description might be in words or it might have a mathematical expression. Call the description a hypothesis. 3. Deduce implications from the hypothesis. 4. Compare those implications with more observations. If the deduced implications are usefully similar to the additional observations, then retain the hypothesis and perhaps call it a model or theory. If the implications clearly do not match the observations then discard the hypothesis (though sometimes you need to check the observation first). 5. Repeat.”
Start reading this book for free: https://a.co/htdR4BV
In computer science it is called the “one off” problem, aka one tag/bracket off!
In my opinion, the starting point for why “Everything is wrong with modern economics” is that economists do not start by talking about the purpose of an economy. How can you meaningfully analyze a complex system without knowing what it is supposed to be doing? I know everyone reading these posts pretty much agrees with most of the criticisms that appear here, so I would be very interested to know what you all think the purpose of an economy is. Starting there, it’s not exactly rocket science to work out whether it is accomplishing that purpose, how efficiently it is working, what kinds of things might be done to make it less wasteful, and what public policies might help prevent the most destructive side effects. If you have a couple of minutes, would you mind writing a little about what you think the purpose off an ecoomy is?
The purpose of production is consumption in the most technologically efficient, ecologically sane and ethically humane ways possible. The current monopolistic monetary and financial paradigm of Debt Only as the sole form and vehicle for the creation and distribution of money lays directly across all of these purposes and is the deepest reason that most of our economic, ecological, social and political problems are kept in suspension. Finding the right new monetary and financial paradigm concept and then implementing it is the first order of business.
deshoebox that’s a good question. A preceding question is ‘What is an economy’. My answers are
“An economy is the set of activities through which a society provides for its material needs. An economy emerges from the exchanges of goods and services in which the society’s members engage. A society, in turn, emerges from the social interactions of a sufficiently large group of people.
The purpose of an economy is to provide sufficient goods and services for the society and its members to survive and thrive indefinitely into the future. Thus not only should individuals be able to survive and thrive, but the society should also be able to continue in a form that is acceptable to its members.”
“Survive and thrive” is not at all the same thing as efficiency (by what criterion?), and society should determine the form of the economy, not vice versa.
WHY WE NEED A HOLISTIC ECONOMIC MODEL
There are many examples in the modern world showing how this doctrine of the free market—the pursuit of self-interest—has worked out to the disadvantage of society.
— CAMBRIDGE PROFESSOR JOAN ROBINSON, 1977
The approach used here concentrates on a factual basis that differentiates it from more traditional practical ethics and economic policy analysis, such as the “economic” concentration on the primacy of income and wealth (rather than on the characteristics of human lives and substantive freedoms).
— NOBEL LAUREATE AMARTYA SEN,
DEVELOPMENT AS FREEDOM
What makes life worth living? Ask economists, and their answers will depend on their view of how the economy works, and on their criteria for evaluating economic performance. In free market economic models, a person’s well-being is measured by “utility” (satisfaction), which is in turn measured by income, and a country’s well-being is measured by its market output or total income. The free market judges a country’s performance by how fast its income is growing, but it ignores the distribution of income within that country.
In Buddhist economics, people are interdependent with one another and with Nature, so each person’s well-being is measured by how well everyone and the environment are functioning with the goal of minimizing suffering for people and the planet. Everyone is assumed to have the right to a comfortable life with access to basic nutrition, health care, education, and the assurance of safety and human rights. A country’s well-being is measured by the aggregation of the well-being of all residents and the health of the ecosystem.
In simplest terms, the free market model measures prosperity by focusing on growth in average income per person and in national output, while the Buddhist model measures prosperity by focusing on the quality of life of all people and Nature. (Brown 2017, 2-3) [ https://a.co/f6d3fE6 ]
This has changed deshoebox’s question, from ‘what is the purpose of economics?’ to ‘how do different systems work? Not that makes what Meta is saying irrelevant. On the contrary, my sticking to the blog’s question of ‘what went wrong?’ follows Robinson in mentioning ‘methodological individualism” and Sen’s ‘Buddhist’ corrective in focussing on humans growing up in families with their environmental needs supplied: our becoming capable of acting independently by learning to control our own bodily functions, hence freedom to NOT act.
Yes,deshoebox, a good question, and Geoff, a good answer. I put the same thing somewhat differently: it is the human form of dads and mums busy feeding their kids while their elders offer advice. Evolution has moved on another phase, with the advice institutionalised in a control system comprising banks, share markets, insurance and portfolio management, with abuse of the latter changing its purpose from controlling the economy to controlling the money flow. But as Craig implies, banks claiming credit is debt reverses its direction, drawing money out of the economy and directing it to the banks (which with a philosophy of ‘methodological individualism’ means ‘to the bankers’).
Lars Syll is making a simple confusion between additive and multiplicative processes. Arithmetic average is for additive process, whereas geometric average is for multiplicative process.
In a additive process, plus 20 % ( + 0.2) and minus 20 % (- 0.2) are symmetric opposite. If you take arithmetic average (average in the additive process), it gives you ( S + 0.2 S) – 0.2 S) / 2 = 0. The average return of this process is 0.
In a multiplicative process, the symmetric opposite of plus 20 % (= 1.2 ) is 1/ 1.2 = 0.833… .
If you take (1.2 S)×(1/1.2), it gives you the initial value S. Geometric average is square root of 1.2 times (1/1.2) is 1. Average return of this process is 1 which is equivalent to 0 in additive process (log 1 = 0). Two processes {R ,+} and {R+, ・} are structurally isomorphic. Isomorphisms are exp and ln (natural log).
If you want a new economic model and new purposes for it you have to look for its major outness (money, debt and banking), discern the paradigm concept of that outness and then replace it with a new concept that fits seamlessly within the legitimate structures of the pattern under consideration and yet changes its character while resolving its major outness. The means of that new conceptual implementation requires a new insight or insights.
This is the scientific, philosophical and paradigmatic process. All else may be legitimate research, but at best is only palliative reform and at worst habitual abstraction and regurgitative erudition.
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On page 437 Karacaoglu writes, “Our public policy platform is the concept of ‘love’ …. The objective of public policy is to make it possible for individuals and communities to live the kinds of lives they value.” Further it is noted:
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