Julio Huato asked:
Why oh why can't we have better theories of the crisis?
A better theory of the crisis requires insight into the "state of
character" dominant in financial markets. Such insight itself
requires a "state of character" with the requisite developed
capability - the requisite "virtue".
Consequently, if society in general is so organized as to "fetter" the
development of such "virtue" and economics is so organized as to make
dominant a mentality particularly deficient in it, economics, as
presently organized, will not be able to develop better theories of
the crisis.
In fact, the state of character now dominant in economics is the state
explanatory, in significant ways, of the crisis.
For instance, the explosive growth of derivatives markets as well as
the psychopathology dominant in them is closely connected to mistaken
and irrational ideas about financial markets deriving from economics.
The influence of economics, as represented initially by Malkiel,
Quandt and Baumol and later by Black, Scholes and Merton, on this
growth and on derivative market behaviour is documented by Donald
MacKenzie and Yuval Millo in an article, "Constructing a Market,
Performing Theory: The Historical Sociology of a Financial Derivatives
Market", in the July 2003 issue of the American Journal of Sociology.
That the relevant ideas - those constitutive of "mathematical finance"
- are mistaken and irrationally anchored (as opposed to, as MacKenzie
an Millo assume. an embodiment of "rational egoism") is demonstrated
by Keynes.
He also connects them to the psychopathology - the state of character
dominated by "greed" - dominant in financial markets and explanatory
of their characteristic features, specifically of liquidity crises.
In the present crisis, the "conventional" forecasting techniques that
hid not only "uncertainty" in Keynes's particular sense but also the
practical certainty of default on many of the subprime mortgages
bundled into mortgage backed securities apparently were, to a
significant degree, "pretty, polite techniques" deriving from economics.
The state of character dominant in economics also explains why
Keynes's "better theory" of liquidity crises has proven
incomprehensible to economists.
The mentality dominant in economics is impervious to the following set
of related ideas.
First, the general psychological idea that "there are insane and
irrational springs of wickedness in most men."
Second, the more specialized psychological idea that "the essential
characteristic of capitalism" is "the dependence upon an intense
appeal to the money-making and money-loving iinstincts of individuals
as the main motive force of the economic machine."
Third, the idea, connecting this idea to the first, that these
"instincts" are expressions of psychopathology, e.g "the love of money
as a possession ... is a somewhat disgusting morbidity, one of those
semi-criminal, semi-pathological propensities that one hands over with
a shudder to the specialists in mental disease."
Fourth, the idea connecting this psychopathology to financial
markets, the idea that the
"vast majority of those who are concerned with the buying and selling
of securities know almost nothing whatever about what they are doing.
They do not possess even the rudiments of what is required for a valid
judgment, and are the prey of hopes and fears easily aroused by
transient events and as easily dispelled. This is one of the odd
characteristics of the capitalist system under which we live, which,
when we are dealing with the real world, is not to be overlooked."
Fifth, the idea that the psychopathology involved - "greed" elaborated
as "the instinct of avarice" - explains liquidity crises:
"partly on reasonable and partly on instinctive grounds, our desire to
hold money as a store of wealth is a barometer of the degree of our
distrust of our own calculations and conventions concerning the
future. Even though this feeling about money is itself conventional
or instinctive, it operates, so to speak, at a deeper level of our
motivation. It takes charge at the moments when the higher, more
precarious conventions have weakened. The possession of actual money
lulls our disquietude; and the premium which we require to make us
part with money is the measure of the degree of our disquietude."
Sixth, the idea that "econophysics" in general and "mathematical
finance" in particular are expressive of the same psychopathology.
"it was, I think, an ingredient in the complacency of the nineteenth
century that, in their philosophical reflections on human behaviour,
they accepted an extraordinary contraption of the Benthamite School,
by which all possible consequences of alternative courses of action
were supposed to have attached to them, first a number expressing
their comparative advantage, and secondly another number expressing
the probability of their following from the course of action in
question; so that multiplying together the numbers attached to all the
possible consequences of a given action and adding the results, we
could discover what to do. In this way a mythical system of probable
knowledge was employed to reduce the future to the same calculable
status as the present. No one has ever acted on this theory. [This is
no longer true as the role of options pricing theory in derivatives
markets shows.] But even today I believe that our thought is sometimes
influenced by some such pseudo-rationalistic notions." (Collected
Writings, vol. XIV, p. 124)
Seventh, the idea that the psychopathological purpose of this
"extraordinary contraption" is avoidance of anxiety by, among other
defenses, denying - "overlooking" - the "awkward" facts that provoke it.
"the necessity for action and for decision compels us as practical men
to do our best to overlook this awkward fact [that 'we simply do not
know'] and to behave exactly as we should if we had behind us a good
Benthamite calculation of a series of prospective advantages and
disadvantages, each multiplied by its appropriate probability, waiting
to be summed." (XIV, p. 114)
Eighth, the idea that the nature of the psychopathology involved means
that the "conventional" forecasting practices that enable individuals
"to behave exactly as we should etc" "are liable to collapse", that
"the vague panic fears and equally vague and unreasoned hopes are not
really lulled, and lie but a little way below the surface.
"a practical theory of the future based on these three principles [the
three forecasting 'conventions'] has certain marked characteristics.
In particular, being based on so flimsy a foundation, it is subject to
sudden and violent changes. The practice of calmness and immobility,
of certainty and security, suddenly breaks down. New fears and hopes
will, without warning, take charge of human conduct. The forces of
disillusion may suddenly impose a new conventional basis of
valuation. All these pretty, polite techniques, made for a well-
panelled boardroom and a nicely regulated market, are liable to
collapse. At all times the vague panic fears and equally vague and
unreasoned hopes are not really lulled, and lie but a little way below
the surface." (vol. XIV, pp.114-5)
The resurfacing of "vague panic fears" initiates the liquidity crisis.
Ninth, the idea connecting these psychopathological "conventional"
forecasting practices to the "classical economic theory" "of how we
behave in the market place".
"Though this ['conventional' forecasting] is how we behave in the
market place, the theory we devise in the study of how we behave in
the market place should not itself submit to market-place idols. I
accuse the classical economic theory of being itself one of these
pretty, polite techniques which tries to deal with the present by
abstracting from the fact that we know very little about the
future." (vol. XIV, p. 115)
Ted
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