As mentioned in the previous post, Post Keynesians argue with mainstream economists (Neoclassicals, New Keynesians, etc.) over the ergodicity assumption in mainstream models.  The ergodicity of economic data is, however the wrong argument to be having because it presumes the use of improper tools for economic analysis.

Ergodic processes allow their parameters to be deduced from a statistically significant sample of data.  Human action, or any subset of it, does not have constant parameters because humans are not predictable in the way that particles, for example, are, due to subjective and ever changing  preferences.  Particles in water or moons orbiting a planet are ergodic, human behavior is non-ergodic.

Put another way, non-ergodic processes are path dependent, meaning their history, the path the system took to reach its current state, has some bearing on its future development and that there are many possible equilibriums for a system.  This seems to be a valid assumption and provides an important place for the history of economics.  Mainstream theory denies path dependency and places man, at least in its method of analysis, in the realm of automatons or particles, always seeking some predetermined, “natural” equilibrium.  Mainstream economists want economics to be a quantitative discipline like the hard sciences, devoid of historical analysis.

This application of mathematics to the study of human action leads to many problems.  The Post Keynesians take the non-ergodicity of human action a step further and proclaim that ontological uncertainty exists in economics, a philosophical step towards nihilism where even the use of general economic axioms is questioned.  The possibility of economic coordination would even be in doubt.

The mainstream economists deny the existence of ontological uncertainty and maintain that the goal of economics is to reduce our epistemic uncertainty through the use of better models containing better mathematical techniques.

Both sides are wrong:  the Post Keynesians in their flirtation with nihilism and the mainstream with their belief in the resolvability of the problems with mathematics.

There is another way, however, which does not rely on mathematical techniques and in which the problem of ontological or epistemic uncertainty does not even need to be decided.  Whether or not future psychologists will be able to predict human behavior, whether or not free will exists, is not important now.  Extreme uncertainty, not the mild uncertainty of a random walk, exists for us now, regardless of our future ability to tame it (doubtful though this is, and undesirable as it would reduce man to a predictable physical process).

The Austrian School uses deductive, a priori reasoning as the only valid means of coming to certain conclusions regarding human action, and an Austrian view of uncertainty is described in Chapter 6 of Mises’ Human Action.  Class probability, where the frequency of a large number of events is used to assign a probability on future events, is applicable to many areas of the natural sciences, despite its use by mainstream economics.  Case probability, where each event is unique, is not open to numerical analysis, since some or all of the relevant factors are unknown, but is the proper method of analyzing economic events.

The outcomes of some types of human action are able to be known with certainty, though not with mathematical certainty.  The law of supply and demand holds, but the magnitude of the change in one due to a change in the other remains unknown.  Constant relations do not exist,  utility curves are not continuous, and a change in one factor can change the relative positions of many other factors.  The use of mathematics in these questions adds nothing to our understanding of economics.  Instead, it can be harmful by providing a false sense of scientific certainty where none can exist.

Sources

http://ineteconomics.org/blog/inet/paul-davidson-response-john-kay

http://www.econlib.org/library/Mises/HmA/msHmA6.html

The intra-Keynesian fight over correct macroeconomic policy is a good lesson in the importance of epistemology in economics.  A good overview of the current debate is presented here.  Basically, mainstream Keynesians like Paul Samuelson and Paul Krugman are accused of  combining Keynes’ ideas with neoclassical thought and producing a watered down version which is devoid of the insights which made the Keynesian theory valuable in the first place. These modern Keynesians, according to the true believers, incorrectly believe that the market system is basically efficient and only needs tweaking by government action to remedy such features as sticky wages in order to fix a recession, which should be done by government deficit spending and easy credit, in that order.

Paul Davidson, leading Post Keynesian, in his book “The Keynes Solution: The Path to Global Economic Prosperity”, says that the crucial insight in Keynes’ General Theory is that uncertainty causes people to hold cash at a level that causes demand to fall, resulting in an equilibrium with unemployment, described here.  Unlike Samuelson and Krugman, who believe markets to be for the most part efficient, Davidson follows Keynes in seeing uncertainty as a permanent negative force on an economy.  Keynes also alleges that financial markets and investing are less based on rational analysis than they are on emotion or “animal spirits”.  These two factors are the reasons investment should be socialized.

Now we reach the epistemology.  The modern Keynesians and neo-classicals believe that accurate spot and futures markets exist, and that the past and present can be used to predict the future, what they call the ergodic principle.  The beginning of the Wikipedia article on ergodicity says all we need to know about the problems with current macroeconomic epistemology:

“In mathematics, the term ergodic is used to describe a dynamical system which, broadly speaking, has the same behavior averaged over time as averaged over space. In physics the term is used to imply that a system satisfies the ergodic hypothesis of thermodynamics.”

Human beings’ economic behavior is assumed to behave like inanimate particles, which obey known statistical properties.  Unfortunately, humans act in accordance with no known statistical distributions and with no fixed correlations or magnitudes, making predictive models impossible and any policy prescriptions based on those models suspect.  Modern Keynesians like Samuelson believed in ergodicity, a mild, understandable randomness with known parameters.

Keynes disagreed with this and saw uncertainty everywhere.  People sensed their inability to predict the future and this kept them from investing in long term projects.  Demand falls, conditions worsen, people hold even more cash to guard against uncertainty, and the economy spirals down.  At this point, the government must start making up for the lost demand by deficit spending.  As demand picks up, investment will increase and the economy will improve.  So sticky wages or the money illusion are not the main problems in this higher level of Keynesian analysis.  It is the uncertainty and fear of investors which is at the root of low demand.  Constant government pressure must be maintained against the under-investment due to uncertainty, which is lost on the modern Keynesians who advocate action only in the face of recession.

Keynes defined effective demand to be the income from production where aggregate supply (total expected income required to hire some number of workers) equals aggregate demand (total expected income due to hiring that number of workers).  Keynes says that effective demand could be in equilibrium with large scale involuntary unemployment.  This is where the General Theory comes in (so named to be compared with Einstein’s generally valid relativity as against Newton’s more special case of mechanics.  Keynes was trying to say that Classical economics, which focused on the distribution of given output, was only valid in the special case of full employment.  The General Theory broadened the scope of analysis to the laws of the size of output).  If effective demand is in equilibrium with involuntary unemployment, then the classical view that workers supply labor up until the disutility of labor equals the utility of the wage is only valid in the “special case” of full employment, not in general.  Effective demand is at this point because consumer demand and investment is too low for the employment of all available resources.

Keynes believed that effective demand with involuntary unemployment disproved Say’s Law, which he took to mean that aggregate supply and aggregate demand will be equal and that this would occur with full resource employment.  Say actually says that production leads to the ability to demand.  Something must be created in order to exchange it for something that someone else has created.  This is easy to see in a barter economy, but the issue becomes more complex in a money economy with wage labor.

How did Keynes propose to break out of the trap of effective demand equilibrium with unemployment, an equilibrium which perpetuated a cycle of underemployment and underinvestment?  He focused on the marginal efficiency of capital, or IRR in modern terms.  Capitalists would borrow money to buy capital goods until the point where their marginal efficiency equaled the interest rate.  Keynes argues that the interest rate should be pushed down, approaching zero, in order to induce more capital investment, increasing the price of capital, and the marginal efficiency of capital would approach zero (Keynes, and modern neo-classicals and New Keynesians, interestingly consider capital to be a homogeneous stock of goods.  Therefore capital is spoken of in general and in the aggregate and “its” marginal efficiency can approach zero).

This is where Keynes’ famous “euthanasia of the rentier” comes in.  Since investment has been socialized, the capitalist class which has benefited from the scarcity of capital by renting it out will be done away with.  Investment capital will be made available at zero percent interest, capital goods will be bought, and a new effective demand equilibrium with full employment will be reached.

Now let’s move from a barter to a money economy.  Instead of direct exchange of goods, a medium of exchange is used for transactions.  Saving and borrowing take place.  Is this system more likely to break down and require the help of experts?  Money has its own supply and demand, its own objective value based on how many other goods it can exchange for, and each actor in the system places a subjective valuation on money.  Like all other goods in which he deals, each person chooses to hold some money in his inventory or to trade it for other goods.  This could be due to his expectation of the future value of money, his desire for other goods than money at the moment, or because he prefers the increased optionality that holding money gives him and which holding other goods does not.  Regardless of the reason, as more people hold money, the scarcer and more valuable it becomes, and the more people are willing to pay in interest to borrow it.  The interest rate is always moving to coordinate the supply and demand of money loans.

How is the money interest rate set?  It is based on the natural rate of interest, which is the difference in the price of a good today versus its price at some time in the future.  If someone can borrow $100, buy raw materials, convert them into a finished good which can be sold in one year for $110, he will pay up to 10% interest for that loan.  The market for money and the information it conveys allows for the supply and demand of other goods to tend toward equilibrium.  The existence of money in an economy allows for an increase in the division of labor, as some people will choose to exchange their labor for money instead of producing an entire good on their own.  This allows for greater specialization and it increases efficiency, so this would not seem to be a destabilizing force necessitating the benevolent wisdom of our deus ex machina.

It is at this point, where some people exchange their labor for money, when they become employees of other people, that some say that breakdowns can occur and intervention can become necessary.  It is widely agreed that the money paid to the person in exchange for his work is equal to the marginal product of his labor.  It is also contended that people, specifically workers, will supply their labor until the disutility of one more unit of labor equals the utility of the money received, the wage.

Keynes’ General Theory

John Maynard Keynes disagreed with the second contention, and said that if this were so there would be no involuntary unemployment.  Keynes’ opponents said large scale involuntary unemployment would only exist if real wages were kept artificially high by unions of workers or by governments.  Keynes responded that workers suffered from a “money illusion”, meaning that they did not care much about real wages and instead focused on nominal wages.  So even if prices of consumer goods were falling, and real wages were rising, workers would only see the stagnant or falling nominal wages.  Keynes also argued that workers would not be able to affect their real wages much anyway, since their agreed to lower nominal wages would lead to a fall in prices and thus unchanged real wages (although the fact exists that wages make up only a part of production costs).  Involuntary unemployment would exist, said Keynes, if consumer goods rose relative to nominal wages, in other words if real wages fell, and the supply of and demand for labor increased.

At what number of participants in an economy do the laws of economics change?  Asked another way, at what number of participants does an enlightened, benevolent, exogenous force need to step in to the system from above to use force or to manipulate the system for the participants’ own good?  This of course presupposes that the benevolent outside force possesses some knowledge of which the system’s participants are unaware and that he can use this knowledge for their good.

In a two person, cooperating economy, both actors are aware of their needs, the other’s needs, their capabilities, and the other’s capabilities.  The level of communication and the awareness of each other’s comparative advantages would be such that coordination of production would be simple.  Shortages due to natural factors or personal limitations could arise, but these would be out of the control of the actors and could be mitigated through the creativity of the two people.  A third party with more knowledge of some production technique could offer advice, but he would then be entering the economy, even if he chose to abstain from trade (he would have to be autarchic).  The same could be said of systems of three, four, or more people.  At some number of participants, however, the actions of all other participants could not be known by every other actor, so personal coordination could not take place.  On the other hand, the likelihood that someone or some combination of people will produce the goods desired by any one person increases with the number of participants in the economy.  The likelihood that some outside expert would possess knowledge unknown to any other participant decreases with the number of participants.  Does the likelihood of discoordination also increase with the number of participants?  Is each actor more secure or less secure in a two or three person economy than in an economy with more participants?  Is there an optimal number of participants?

Let’s say that for a barter economy the answer is no, that the economic laws do not break down with some high number of participants and that people in general are better off and less likely to have unfulfilled physical wants as more people, each of which is both a producer and a consumer, enter the economy.  Even if some discoordination happened, the economy could divide into smaller units, perhaps by geography, until the optimal number of actors was reached and coordination and stability returned.  What if each actor produces some specialized good which no other person makes and that person leaves the market?  A greater number of actors increases the likelihood that someone else produces something similar and can step in to fill the unmet demand.  The larger system is more robust.

Jean-Baptiste Say described what would later be called Say’s Law to explain how economic downturns are not the result of weak demand, but lack of production.  He says that the ability to demand can only come from a previous act of production, which in the barter economy described above is obvious.  But what happens when money is introduced into the economy and some people, instead of producing finished goods themselves, hire themselves out to others in exchange for wages?  Does Say’s Law still hold?