Tuesday, December 1, 2015

Ecological (or Realist) Rationality in Economics

Those unfamiliar with ecological rationality may be surprised by the term ecological used in in a discussion of economic methodology and methods. For the last century, economic theory has been described increasing in terms of of systems linear equations. In order to be mathematically tractable, this framework assumes homogeneous agents whose preferences are only described in terms of prices and quantities. In this theoretical world, only one price, centrally computed by the Walrasian auctioneer, can exist simultaneously (Axtell 2005). All action is determined solely by preferences regarding price and quantity, couched in terms of utility maximization (Arrow and Hahn, 1971). Agents do not interact with one another directly, but rather, only indirectly through the prices and quantities proffered by the auctioneer. An agent’s decisions to interact with the auctioneer is always a consequence of their desire to maximize utility, a variable treated always as a cardinal measure. This is the core of neoclassical economic theory as it has come to be practiced professionally.

Not to buck the trend, macroeconomists have followed the same type of pattern. Over the last half century, macroeconomists have built models that employ either macrovariables, representative agents, or both (Hirschleifer. 1970; Kohn 1981; Lucas 1972). The move to DSGE simulations represents an extension of this equilibrium paradigm (Wagner 2011). The relaxation of some assumptions, such as the assumption of perfect information, still leaves economics with the same core. Agents in this paradigm are automatons driven by a singular desire to maximize a utility vector. The motives of these little resemble that of agents in the real world. To the extent that we are wrong, we would prefer not to associate with such avaricious, monotonously motivated agents.

The social world is far richer than the description provided by what has come to be accepted as the neoclassical paradigm. While a perfect model of reality would be redundant, the dominant paradigm lacks the fidelity necessary to be considered a simplified replication of a reality within an open system. Action of economic agents are not driven by solely by price and quantity vectors, although they do interact with prices and quantities. To the extent that they are, a subjective interpretation of price must be employed (Mises 1949). The world which economic agents inhabit is a subjective one. In this world, agents are not only imperfectly informed; they imperfectly perceive the world. They are certainly in no position to optimize (Chaitain, Doria, and da Costa 2011). Even when the world is defined in terms of prices and quantities, agent optimization according to the typical calculus is computationally intractable. In the least this is an insurmountable problem for the Walrasian auctioneer (Axtell 2005).

It is necessary, then, that economic theory not only drop its assumption of perfect information, but that economists altogether reevaluate the perceptual framework that modeled agents inherit. Theory must identify and employ only the elements most significant for the domain of study, but with the realization that agents interact with particular objects at a given place and time. An appropriate framework allows for the appearance of general contexts that represents the details of that contexts as general types. A ecological, or realist, framework of perception and rationality fulfills these requirements.

An ecological perspective can be described as containing heterogeneous and interacting agents. These agents inherently interact with the world in a manner consistent with Bayesian updating.

In the ecological view, thinking does not happen simply in the mind, but in interaction between the mind and its environment. This opens up a second more efficient way to solve the problem: to change the environment. The relevant part of the environment is the representation of the information, because the representation does part of the Bayesian computation [emphasis ours]. (Gigerenzer 2008, 17)
Agents offload computation onto objects and systems of objects that they perceive in the course of their existence. Agents do not optimize, they adopt patterns of behavior that tend to promote predicatable outcomes. One such family of decision-making rules is what Gigerenzer and Goldman term “Fast and Frugal” (1996). Fast and frugal rules allow the agent to make a decision based only on a single piece of information. (Are dark clouds forming to the immediate west? It is probably a good idea to wear a coat until they either subside or until a storm has come and gone. One does not need to check the weather report under such conditions.) Agents do not have the time to collect all available information when making decisions. In a world that is part of an open system and where variables of interest are not independent of one another, a fast and frugal rule actually outperforms regression analysis in predictive power (Gigerenzer 2008, 41). As agents grow accustomed to these rules, they become ingrained in habit and thereby reduce the computational work required by the agent.

Rules that guide agent action take a vast variety of forms. For example, an agent investor may only invest according to fundamental measures. Others may invest according to past data. Still others may copy the investment decisions of investors who consistently beat the market. An obvious consequence of action guided by these rules is agent interaction. Agents influence one another by influencing conditions of scarcity and by interacting with and copying one another directly. The first of these is accounted for, if only imperfectly, in the modern formulation of economic theory. The latter is non-existent in that realm. A convenient approach to framing this latter problem is in terms of an information cascade where the information transferred is a decision making rule (Earl, Peng, and Potts 2006). The rules that appear to promote an agent’s ends are copied by other agents (Hayek 1962; Bikhchandani, Hirshleifer, and Welch 1998).

Notice that this framework for decision-making fits nicely into a theory of expectations that does not assume the end it is supposed to prove. Consider the Lucas critique (1972). Lucas noted that any relationship among macrovariables will tend to disappear one it has been recognized. Proponents of rational expectation would argue that agents make predictions about the future using all available information and that agent predictions of the future are conveniently distributed around a median outcome that, absent information shocks, represents an accurate prediction (Muth 1961, Fama 1970). This model looks nothing like social reality. It suffers from the same problem that Gigerenzer identifies above concerning Bayesian computation. It has in its favor a modest degree of predictive power, but lacks the fidelity that is required for deeper understanding. The alternative contained within an ecological framework suggests that agents form rules that conform to their interpretation of reality. If agents expect that there will be a high degree of inflation, they will substitute assets in their portfolio in lieu of cash. They only need to know what sort of action to take given expectation of a particular circumstance. Those agents who tend to be better at predicting will tend to maintain larger stocks of wealth than those who predict poorly. As agents receive feedback concerning their actions, they will update if they believe they were following an inferior pattern of action. Over time, this allows strategies to be developed, tested, and either discarded or duplicated.

Roger Koppl describes this process in his theory of expectations. Borrowing from Schutz and Hayek, Koppl posits two types of expectations formed by agents: cognitive and acognitive (2002). Cognitive expectations represent conscious predictions of the world given some information. Conscious predictions, however, are limited in their scope inasmuch as they only affect agent action a single time. Agents also form habits over time that ideally promote their continued existence and prosperity. The old maxim, “early to bed, early to rise,” for example, encourages the formation of acognitive expectations with respect to ones bedtime and waketime. Those who follow must assume that action in concordance with the maxim promotes a state of affairs that is superior to a world where the agent lacks such a habit. Returning to the inflation example, agents may learn to immediately purchase assets – maybe real estate, stocks and commodities – whenever they hear a trusted source of information suggest that there will be inflation in the future. Any misallocations that occur in this process will be smoothed out over time by competing arbitrageurs in the long-run. This does not exclude the possibility of economic volatility in the meantime as relatively ignorant agents compete with one another, collectively discovering the true conditions of the market by a process of trial and error (Hayek 1942; [1968] 2002).

Over the last few decades, substantial progress has been made in understanding of human perception and that perception's interaction with the environment. Reliance on rational expectations by economists have prevented them from taking advantage of this progress. While rational expectations is useful in justifying econometric work which represents the bulk of applied research in the last half-century, there exists an opportunity to return to the mode of realist theorizing that dominated economics before World War II. Finally, I have not mentioned agent based modeling above. Econometric analysis was the workhorse of the most recent epoch of economic thought. I expect agent-based modeling to become the workhorse of economists working with pure analysis. Many of the components for this already exist (see Simon 1996; Hayek 1962; Crawford and Ostrom 1996; North and Denzau 1994; North 2005). It is only a matter of time before these methodologies are employed to create agent-based simulations across our field.

Thursday, November 5, 2015

Hummel Corrects the Dominant View of Banking Crises in U.S. History

Over at EconLog, David Henderson has posted on Jeff Hummel's commentary concerning the inefficacy of macroeconomic policy aimed at curtailing business cycles. I encourage you to take a look. Hummel also notes that banking crisis of the pre-modern era (before 1913) were not as damaging as many historians believe. (see also Selgin, Lastrapes, and White) Some historians have misinterpreted the data as they confuse bank suspensions that occur during panics with bank failures:

Bank Failures
Bank panics, even when accompanied by numerous suspensions (or what Friedman and Schwartz prefer to call “restrictions on cash payments” to distinguish them from government suspensions of redeemability), do not always result in a major number of bank failures.
For instance, Calomiris and Gorton report the failure of only six national banks out of a total of 6412 during the Panic of 1907, or less than 0.1 percent. Of course the Panic of 1907 was concentrated among state banks and trust companies. Unfortunately, as far as I can tell, there are no good time series on the failures of state banks for the period prior to the creation of the Federal Reserve. Yet there were over 12,000 state banks at the outset of the Panic of 1907. One very fragmentary and incomplete estimate of total bank suspensions (rather than failures) in Historical Statistics (1975), including both state and national banks, puts the number during that panic at 153. Even if all suspensions had resulted in failures, which of course did not happen, we still have a failure rate of 0.7 percent for all commercial banks.
Confusion of bank suspensions with bank failures can even infect serious scholarly work. For example, in Michael D. Bordo and David C. Wheelock (1998), charts meant to show bank failures are instead clearly depicting statistics on the annual number of bank suspensions. Similarly, periods of numerous bank failures do not always coincide with bank panics, as the S&L crisis dramatically illustrates. So it is crucial to distinguish between periods of panics and failures, although specifying the latter requires judgment calls. For the monthly number of national bank failures prior to the Fed’s creation, I have depended heavily on Comptroller of the Currency (1915), v. 2, Table 35, pp. 66-103.

The dominant historical narrative tends to follow the stale formula of:
1. Market Fails
2. Government Intervenes
3. Social Welfare Improves
I know this story from somewhere...

Tuesday, October 6, 2015

Equilibration without Scalar Utility: Formal Non-equilibrium Modeling (Sneak Peak)

This is what equilibration looks like when agents coordinate action without agents who consider the MRS as derived from scalar utility. The lower boundary represent the price that is represented by the ratio of desired reserve levels for each of the two goods in the model. Non-equilibrium modeling provides equilibrium results. I hope to have the paper up by the weekend.

Thursday, August 27, 2015

Austrian Cycle Theory: More Than a Theory of Inflation Driven Boom and Bust

Yesterday, David Henderson asked me "can you look at the stock price drops of the last week and say with much confidence that they are strongly confirming of ABCT?" I responded that we cannot know for certain. The more I thought about it, the more I thought that this is not the right question to be asking.

Austrian business cycle theory is an extension of price theory. As long as expectations are convergent, we can expect prices to tend toward an array that reflect underlying scarcities and demands. If expectations are not convergent, then we can expect increased volatility. As humans, we gain much of our knowledge by observation of others. This leads to a tendency for expectations to be subject to herding (Koppl and Yeager 1996). The more uncertain the future, the more likely expectations will be disparate. For at least as long as disagreeing agents remain solvent, this volatility will persist. Discoordination persists as relative prices fail to reflect  underlying economic reality. 

We can be certain that the mechanics of Austrian cycle theory are always in operation. 

The effect of discoordination of relative prices is always in force. Entrepreneurs and firms in the market are often able to withstand the volatility. This does not change that these agents are interacting with distorted prices. Movements in relative prices always affect the production structure. Sometimes price distortions do not greatly impact system stability. Sometimes they generate numerous insolvencies. In the current crisis, Austrian cycle theory seems to hold in China as myriad distortions have left the market in disarray. 

Confusion arises from the Austrian emphasis on inflation and inflation's relationship to the natural rate. Murphy argues that "the Federal Reserve was setting us up for another crash." How was it setting us up for another crash? Murphy points to the Fed's increased balance sheet as evidence that it has set the economy on course for a slump. He provides the traditional argument that the interest rate has been pushed below the natural rate.
However, what happens if interest rates fall not because of a genuine increase in saving by the public, but rather because central banks flood the financial sector with newly created money? According to the Austrians, this typical remedy merely sets off an unsustainable boom. Entrepreneurs still get the green light to start longer term investment projects, but the economy lacks the real savings necessary to bring them to fruition.
This version of the story is not as powerful as most Austrians think. Firms can substitute toward cheaper inputs as prices rise. Consumers can substitute away from goods that have become to expensive. Projects can be completed, but they may be completed at a loss. If losses accumulate, credit markets may seize for as long as their is a perception of high risk and/or a rate of expected deflation. The structure of production may lengthen, but discoordination occurs on more than one dimension. The story presented by Murphy is incomplete.

The core of Austrian cycle theory is not overconsumption or overproduction. Garrison's presentation with its use of the Hayekian triangle and emphasis on interest rates, demonstrate this version of Austrian cycle theory (edit 926 EST). The theory is more general than this. All relative price distortions lead to overproduction of some goods and under production of others. Inflation tends to make overproduction more common, as reflected by Garrison's movement off of the production possibilities frontier. Central bank policy contributes to this, especially when changes in the money stock are substantial and central bank action is unpredictable. 

This logic applies to more than central banks. All state intervention into the economy tends to be distortionary. The greater the magnitude of the intervention. the less sensitive is the structure of production to the actual needs of consumers. Unlike private agents, the state is not especially responsive to profit and loss as its funds derive from a different revenue stream: taxes. When relative prices are perpetually distorted by interventions and policy uncertainty, profit and loss becomes less effective in promoting expectations that reflect the underlying economic reality.

Thinking about prices and coordination:
Hayek - Socialist Calculation I, II, and III 
Hayek - Economics and Knowledge 
Hayek - The Use of Knowledge in Society 
Mises - Economic Calculation in the Socialist Commonwealth


Wednesday, August 26, 2015

Re: David Henderson: A Defense of Austrian Business Cycle Theory

At EconLog David Henderson is asking:
Question for Bob Murphy and other proponents of the Austrian Business Cycle Theory: is there any evidence conceivable that, if you believed it, would convince you that your theory is wrong?
This was in response to Robert Murphy who David quotes:
As shocking as these developments [drops in stock prices and increased volatility] may be to some analysts, those versed in the writings of economist Ludwig von Mises have been warning for years that the Federal Reserve was setting us up for another crash.
The logic that is implied by Murphy's statement, that Austrians have been warning about this for years, does not imply that they are right about the current problem. Saying "we were right" does not make it so. Murphy's story has not inspired David's confidence. Perhaps I can inspire some confidence.

The core of Austrian Business Cycle Theory proposes that changes in the money stock, whether due to gold discoveries (when that mattered) or credit expansion, alter relative prices. This leads to overproduction in some sectors and under production in others. As long as these distortions remain small, the economy will probably not be greatly destabilized. If the array of relative prices, which reflects consumer demands and existing and expected supplies, are continually pushed away from an array that actually reflects these factors, instability grows more likely and business fluctuations may increase in size or number.

Expectations may help offset the distortion; they may not. We are accustomed to thinking of expectations in macroeconomics as expectations about the price level. As long as velocity remains relatively stable, agents may form expectations that often approximate future changes in the price level. This is not the object of significance in the Austrian story. It may have features that coincide with price level movements. The argument stresses that movements in and the formation of expectations about a price level are not the prime cause of fluctuations, although high levels of expected deflation can be responsible for dysfunctional credit markets, as they were during the Great Depression. Typical monetarist analysis, despite all of its success and usefulness (i.e., the cash balance interpretation of depression) does not account for the story concerning relative prices.

We can expect that, in the short run, relative prices will be distorted and that this distortion increases as the size of the injection increases. We cannot expect a full and immediate adjustment of prices as knowledge exists only in dispersed bits. Those bits of knowledge are born from varying interpretations that have contributed to and been formed in part by the agent's interpretive (cognitive) structure. Distortion derived from interpretation increases as agents face greater uncertainty (edit 1826 EST) (Koppl 2002). We've been living in an atmosphere of elevated uncertainty for a decade.

Tuesday, August 25, 2015

Realist Theory and Complex Methods: The Path Toward Integration

In its purest form, economic theory describes its domain of study as it actually exists. Reality is not comprised of homogeneous agents who choose quantities of goods according to the mariginal unit of utility gained per dollar spent. If only life were so simple! In the real world, agents have no option but to make choices that confront scarcity of time and resources. These choices are often aided by some standard or algorithm. In some cases, choices appear to be random. Despite this, order in society is apparent enough to suggest to the observer with even a slight inclination toward introspection that the persons around her act with ends in mind; that there must be some process by which society organizes itself toward the ends of its agents.

James Buchanan identifies much of this order in the form of rules that govern human action and interaction. Douglas North took this a step further, arguing that the rules and order that appear in society first arise in a mind or minds. The rules of the mind come to impact the rules of the game and their structure. This may happen simply through duplication of the rule governed action by others, or may rely on a complex, iterative processes of instantiation. Herbert Simon showed us that humans are ecologically rational, using the information present in their surroundings to guide their actions. This is a process of necessity for humans to function in a world that is best described as an open system and where one's own computational power is limited both by physical and structural constraints of the mind. Hayek (1952; 1960; 2014) delved further into the nature of rules, perception, interpretation, and action, providing a general language that made many readers confuse his economics for something approaching philosophy.

The wisdom of those great economists who have come before us serves as foundation for a new framing of economics. This starts with a reconstruction of the agent along the lines suggested by the economists above mentioned, as well as researchers in the adjacent disciplines which include philosophy, sociology, cognitive science, computational and computer science. Carl Menger dreamed of building a robust economic system that integrated essential innovation in formal knowledge of mind, human action that flows from the mind, and the society that arises as a result of human action. In some ways, Mises (1949) fulfilled this dream in human action. However, unaddressed problems concerning epistemology made his contribution fodder for those who do not appreciate the implications of his argument. Hayek corrected much of this with his work from the Abuse of Reason project. It is no coincidence that he is highly cited by those who study the emergence of institutions.

Many recognize that Hayek's work in this domain is valuable, but I have yet to see a substantial integration of his ideas with the core of economic theory. Many researchers in institutional economics have picked up the torch that he passed. Elinor Ostrom credits Hayek (1937, 1945) for her understanding of the emergence of social institutions that help to govern the commons. A similar appreciation is true for North and Denzau, as well as more recent work from Boettke, Coyne, and Leeson. The latter of these note that Hayek "was among the first to emphasize these aspects of spontaneously emergent institutions (333)." Koppl (2002) advises us to consider the internal state of the economic agent with reference to his perception of the external world. He argues that agents form expectations according to types that they have constructed or borrowed from others. (When I approach a cashier, I do not necessarily expect to make a friend, but I can be nearly certain that he will facilitate my purchase.) Agents have mental maps - private ontologies - which are comprised of a mixture of anonymous and personal typifications and rules that are believed to govern the existence and interactions of objects represented by these typifications.

The work of all of these mentioned have helped move economics toward the cusp of a change that has been building throughout the last half-century. Their work is part of a line realist theories that trace their lineage back to early economists like David Hume and Adam Smith who were not afraid to recognize, and even awed at, the complexities inherent in social interaction. These contributions represent a more scientific rendition classical political economy. This is synonomous with Wagener's "entangled political economy."  Their work is integral to the resuscitation and development of a paradigm of realism to underlie the work of economists.

Not long after the Samuelsonian turn in economics, theorists on the margins of the discipline - and some like Arrow who was certainly not on the margin - began to employ a new set of tools. These tools are part of the complexity paradigm. Researchers within this practice investigate emergent processes and the objects and structures that the processes generate. Of primary concern for economic theorists are agent based models. Some popular models include Shelling's (1971) segregation model, Axelrod's (1997) conflict model, and Gode and Sunder's (1993) zero-intelligence trader model. Theoretical contributions are arising from this line of inquiry. Gode and Sunder show that the process of coordination is an outcome of simple rules governing the buying and selling of goods. Axtell (2005) demonstrates that exchange is a process of social compuation! These theorists have created a number of innovation that other economic theorists can integrate into their own practice and understanding.

Now to bring these treasures together into a cohesive framework. A robust economic theory must explicitly identify its objects of concern, relationships between objects, and processes that govern these. Emphasis on rule-based perception and coordination is critical for understanding the core of social processes. Perception is at the foundation of agent action. Agent-based modeling provides a method to which a methodologically robust rendition of economic theory can be applied. Integration of these will provide us models that not only explain and demonstrate economic theory. The same platform also allows us to produce models whose predictions take economic process into account.