Liquidity Trap, Banks & Fiscal Policy

Monetary policy is usually considered potent enough to cure all evils. If the economy is not growing fast enough - the central bank buys treasuries for cash from banks, thus releasing more money into the system for circulation. The economy is overheating, it does the reverse. Equivalently, it can also lower or hike interest rates by fiat. A decision by the central bank to buy treasuries for cash or to decrease interest rates has the same effect - it increases the price of the treasuries and makes it desirable for banks to sell them and invest the proceeds elsewhere.

All this assumes a normal economy where a bank has no incentive to hold reserves in excess of what it is legally required to do and where treasuries and cash are not good substitutes for each other. In a crisis, the economy is not in a normal situation. Interest rates could be touching zero (as they are now) and treasuries and cash become almost substitutable. If the central bank now starts buying treasuries for cash from banks, the banks will happily take the cash and sit on it. They will keep reserves much in excess of what they are required to, as they don't have confidence in private assets, treasuries are equivalent to cash and the possibility and fear of a bank run (or a loss of confidence in the banks' assets) makes it prudent to keep more reserves than is mandatory.

The part where banks consider the excess cash as a substitute for treasuries and hold on to it (just like they were holding on to treasuries) is the liquidity trap. The part where banks hold excess reserves due to fear, let's call that a 'solvency trap'.

To get past this situation, Keynesians recommend fiscal stimulus. The government issues new treasuries, this increases the interest rate on treasuries, people buy treasuries (through banks) and the government has cash to burn. Of course, some of the excess cash will also be used up to buy existing treasuries from the central bank itself, i.e fiscal stimulus will also have the effect that a mild monetary contraction in the form of an interest rate hike does. This can be avoided by concurrent monetary expansion by the central bank.

Irrespective of any such concurrent monetary policy measure, fiscal expansion ensures one critical thing at least - the government borrows from lenders because the private sector is not able to. The average willingness to spend cash has increased. The government can then spend the money in various ways. It can choose to invest in infrastructure and aim at the positive network effects to boost the economy. It can reduce the debt burden of households and businesses by re-capitalizing them. Or, it can decide that it has no competence in choosing and privileging specific households and businesses and instead just aim at getting the stimulus to work through the banking system by giving cash back to the banks.

But lack of cash with banks was never the problem - the willingness to get it moving was! And the government is not going to just make a donation to the banks. So what happens in a fiscal stimulus that operates through banks anyway?

Well this is what I think happens. Government issues new debt, lenders of all hues move cash from banks to treasuries. The balance sheet of the banking system shrinks. The banks also buy up some more treasuries from the central bank. Now the government is going to give this cash back to the banks in exchange for something. What is this something?

It won't be treasuries, that will just be a monetary expansion and fiscal contraction. It won't be true short term debt - that's just cash back to the bank and all that has happened is that the bank owes money to the government instead of investors and the government in turn owes money to the investors. It can, however, be long-term debt, or short term debt with the surety that it will be rolled over (which is just cheap long-term debt) or equity. If it is long term debt, the asset liability mismatch of the bank is corrected to an extent. If it is equity, the bank is unlevered a little without a shrinking of the balance sheet. In either case, fiscal stimulus that operates through the banking system fundamentally improves the capital structure and hence the solvency of the banking system. This is bound to reduce the tendency to hold excess reserves and get the money circulating faster.

Conventional monetary policy then just involves a shift between two safe assets of the banking system - it cannot be expected to work when there is substitutability between these assets. Unconventional monetary policy, in which the central bank buys private assets from banks in exchange for cash, also exchanges one asset for another but these are not substitutable. It can, in principle, work.

Bank-driven fiscal policy effectively involves tinkering with the liability structure of the banking system. It can be a way out of the liquidity trap as well as the solvency trap. In fact, it can help the economy escape out of the liquidity trap precisely by getting out of the solvency trap.

Promised Econ Link Fest

1) The Blog Wars : De Long & Krugman vs. the New Classicals

Krugman's main salvo

John Cochrane's reply (reproduced on Karl Smith's site)

Nick Rowe points out Cochrane's mistake

De Long takes apart the New Classical case: here, here and here

David Levine replies to Krugman

De Long replies to Levine

De Long summaries his pet peeves with the New Classicals

Krugman offers a historical sketch

2) Nick Rowe explains why money is not like other goods and assets and hence, not neutral in a non-barter economy, here and here.

3) Steve Keen

Keen is a Minsky style Post-Keynesian. He has written a book called Debunking Economics, which is highly critical of neoclassical economics.

He laments the usual equilibrium analysis of the economy in the mainstream and tries to model the economy as a non-linear dynamical system using differential equations. He argues that money is endogenously created (money is there iff. there is debt). He also sees the modern capitalist economy as inherently unstable (which ties up with the dynamical model) because of the financial fragility hypothesised by Minsky.

4) Barry Eichengreen and Kevin O Rourke on the comparison between this depression and the original great depression.

5) Janet Yellen on what central bankers can learn from Minsky

Yellen is the governor of the Federal reserve of San Francisco. She argues that there is a pressing need to incorporate finance into mainstream macro, that there indeed are asset price bubbles and it may be desirable for a proactive central bank to deflate them. She also says that not all bubbles are equal, and that credit market bubbles and deleveraging need more proactive intervention than equity market booms and busts. She is however skeptical about how a central bank can go about doing it, and suggests countercyclical capital requirements (which go up in times of liquidity and go down in times of distress) as a robust policy measure.

6) 2006 paper by Alan Blinder on the main monetary policy challenges faced by central banks everywhere.

Blinder's only blind spot in the paper was his strong assertion on the issue of asset price bubbles. He asserts that central banks should not be concerning themselves with such bubbles, and gives the example of the tech bubble and bust to demonstrate how asset price fluctuations can be effectively handled post facto. In the light of recent events, it is a particularly bad example. Oh well, hindsight is perfect.

The insights on exchange rate interventions (intervene in extreme volatility), transparency of output and unemployment objectives (its necessary) and bank supervision (it may be required), and the deliberations on interest rate are quite brilliant. Do read the whole thing though - it's clear, smoothly written and really gives the lowdown on the practice of central banking.

7) Minsky & Minsky-like

Financial instability hypothesis

What can I say that hasn't been said before? From wiki,

Dr. Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles endogenous to financial markets. Minsky claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.

This slow movement of the financial system from stability to crisis is something for which Minsky is best known, and the phrase "Minsky moment" refers to this aspect of Minsky's academic work.

Paul McCulley's Minsky inspired take on the 'shadow banking system', a term that he coined. Incidentally, Janet Yellen also refers to McCulley approvingly in her address. Oh well, PIMCO is just a great bond fund.

8) The history, development, state and relevance of macro (the non-vitriolic not-just-post-crisis series),

David Laidler, among the original monetarists, on Lucas, Keynes and macro.

Robert Gordon, on why 1978 era macro might be the best guide to the crisis. Some insightful ideas about the differences in goods that have 'auction markets' (like oil) and others that don't and what that means for macroeconomic theory.

Greg Mankiw, 2006 paper on theory vs. policy in macro. Excellent stuff!

Arnold Kling, in a smart little piece about how shortage of data affects macroeconomic debates of all hues, as a small review of Mankiw's paper.

Michael Woodford, papers on revolution and evolution in 20th century macro (1999), and a somewhat ill-fated celebration of a then new neoclassical 'consensus' in macro. (2007)

Robert Lucas, asserting that smoothening short run demand flucatuations ought to be subservient to looking at long term supply driven growth. This address forms the basis of part of the analysis in the Laidler paper. Recent events don't bear him out too well either.

Have fun!

Money, Macro & the Crisis

Recently, I've found myself reading a lot on the crisis, monetary policy and macroeconomics. This includes the usual suspects, some newly discovered stuff and a book. But most of all, I've been reading research papers, including some that were published a few decades ago. Some sort of clarity and a framework have begun to emerge and I'm now finally able to get the drift on some of the more technical discussions on the relevant issues. There are two prominent themes in these readings that emerge often and that I find myself agreeing with most strongly.

The first is that there is a pressing need to incorporate finance and into macroeconomics. Earlier, this incorporation had stopped at understanding the role of money in the economy with a cursory glance at the banking system. The basic channel that unifies money, the banking system and the real economy is credit and credit has never really been incorporated into mainstream macro. If there is only one thing that we learn from Minsky, it should be this: incorporate credit as the concept and the financial sector as the context to inform macroeconomic policy.

The second theme is that dynamic monetary disequilibrium is a consistent feature of the modern credit economy. If you take a look at the criticisms of the New Classical school (esp. John Cochrane) coming from De Long and Krugman and many others in the recent online economic wars, there is one constant refrain: the New Classical school has failed to grasp the role that money can play in the modern economy. The New Classical school has an implicit belief in the Say's Law, and thus believes that there can be no general supply glut, that excess supply in one sector is offset by excess demand in another, that savings always equal investment and hence recessions are temporary readjustments in overall social preference from some goods and sectors to other. It thus believes in the 'neutrality of money', i.e the idea that money only functions as a medium of exchange, that investment and consumption decisions are made in real terms and hence the only source of demand for money is the 'transactions demand'. As many have pointed out, this is a model that could perhaps accurately describe a barter economy, or to a monetary economy where the velocity of money is a fixed technological constant subject only to exogenous shocks and thus behaves as if it were a barter economy.

While the barter system has not existed for a long time now, the relatively simpler economy of the past, say until the 19th century, could perhaps be approximated by such a model. In an explicitly monetary economy, however, money also seems to perform the function of a store of value and thus there could be disequilibrium, especially a monetary disequilibrium. A fully fledged 'finance economy' has since become the reality in the 20th century, and such a finance economy seems to have the ability to magnify and reinforce the monetary disequilibriums.

There are, of course, a number of people and streams of thought that have tried to incorporate credit into their understanding of macroeconomics and business cycles. Apart from Minsky, the Austrian Business Cycle theory is one such. Broadly, it says that money is easy in good times due to actions of market participants and artificially low interest rates set by the central bank. This excess money causes businesses to over-invest, thus temporarily causing a bubble. Ultimately this bubble bursts, resulting in a temporary under-investment that brings the economy back to its 'normal' state. Central banks should not try to increase liquidity during such a crisis, for that will just create another such bubble. Murray Rothbard's version of the business cycle also has people over-inesting irrationally only in the presence of the central bank!

Because of the resemblance of the boom-bust hypothesis to the technology bubble to mortgage bubble shift of the past decade, and because of its incorporation of credit, this theory has gained some credence in the past year. It has however, been criticized on various grounds at various times by several economists, including both Keynes and Friedman. The central issue with the theory is that it also seems to believe in the neutrality of money. Moreover, the theory seems to treat irrational over-investment as a moral evil and recessions are seen as having the salutory effect of bringing people back to the preferred state of rationality. This can seem as a Great Depression-apologist stance and Krugman has indeed attributed part of the blame for the broad-based central bank failures during the depression to the Austrians.

Apart from the Austrians and Minsky, there was at least one other economist whose ideas seem strikingly close to the events unfolding of the crisis, but who doesn't seem to have gotten much attention. Henry Simons is considered one of the founders of the Chicago school. Simons recognised and distrusted the high volatility of the liquidity demand of money and believed that the credit cycle and short term debt issued by banks and corporations exposed any financial system built on it to severe fluctuations through asset liability mismatches, which could then spread the fluctuation to the real sector. He was also concerned a lot about maintaining the price level. In one theory, we see the amalgamation of several strands of thought that have come to dominate academic thought in the crisis.

Though Simons's understanding of the inherent fragility and positive feedback of the financial system is similar to Minsky's and Bernanke's, his policy prescriptions differ. He recommends full reserve banking, the gold standard, the complete absence of short term debt, and strict monetary management by the government. If these frameworks are in place, it seems to me that the rest of the economy starts resembling an 'as if' barter system and his favoured policy stance of laissez faire becomes workable.

A full reserve banking solution has also been provided by others wary of the financial system or the government, including Rothbard and intermittently, Friedman. The causes of course, differ. The generation of money through fractional reserve banking has been compared to counterfeiting by more than a few respected economists, including Maurice Allais. The debate is not only interesting (though perhaps lop-sided), it is critical to understanding the tenuous relationship between money and credit in the financial economy.

Credit is endogenous, it comes about from the interaction of the financial and the real sectors. Indeed, it is also the main channel of transmission between the two. Proponents of fractional reserve banking argue that it is just the way to implement the 'monetization' of credit. Proponents of full reserve banking are concerned either about the supposedly illusory money (Rothbard, Allais) or about financial fragility (Simons).

Of course, even within the 'monetization of credit' philosophy, one can ask where does the money itself come from. While the monetarists and many Keynesians believe that money, though inevitable, is still exogenous and comes from the government and the central bank as a way to monetize the credit, the circuit theorists argue that money is an endogenous property of a credit economy itself. Indeed, in their view, credit IS money. Of course, there are the agnostics in between these two views.

We can thus summarize the broad ways of looking at the theory and concept of money, arranged in a roughly free market to interventionist order.

1) Money is neutral and always in equilibrium.

2) Money is neutral but there are temporary, required credit disequilibria.

3) Money is not neutral and sometimes in disequilibrium, but exogneous.

4) Money is not neutral and often in disequilibrium, and may be exogenous or endogenous.

5) Money is not neutral, often in disequilibrium and endogenous.

My own views are closest to 4.

(This post has left out several contextually required links. The next one is going to be a mega link fest)

RBI and central banking

If you read Ajay Shah's blog, you will notice that he is an ardent supporter of inflation targeting, rule based central banking and by and large critical of RBI's policy actions. Specifically, he believes that in an emerging country likely to have weak institutions, like India, the central bank has no business using discretion, that currency depreciation should not be fought using fx reserves, that modern academic macroeconomic insights (of the Monetarist-New Keynesian variety) like inflation targeting are widely used and widely effective and that RBI's heavy handed approach to regulation has drastically stunted financial markets and innovation and thus stunted entrepreneurship and growth. Ila Patnaik, with whom he has collaborated on several papers and other research initiatives, has more or less similar positions. I refer to the two of them because of two recent pieces - this op-ed by Dr Shah in FE and this one by Dr. Patnaik in the Indian Express.

Before we turn to the op-eds in question, it is interesting to explore each of the broader positions in some detail. Rule based central banking is thought to stabilize market expectations and prevent the central bank from committing policy mistakes which it might otherwise do on account of insufficient data, incompetence or vested interests. However, it also takes away some important tools that central banks have to fight pro-cylicality. Dr. Shah is however ok with de facto if not de jure central bank positions, but seems to insist that India cannot afford de facto positions because our institutions are weak. This characterization of Indian institutions, while broadly correct if we were only talking in generalities, fails as a logical argument when one specific institution is being discussed, whether the RBI or any other. Rule based central banking could be a great idea if there was sustained evidence of RBI policy failure, otherwise there is no specific need for us to be pessimistic about RBI simply because on the average, Indian institutions are weak. And how has the RBI done? We'll turn to that in some time.

The specific measures of inflation targeting and using fx reserves to fight currency depreciation are trickier issues. Basically, as this article by Raghuram Rajan points out, the two objectives cannot be managed well together with a single instrument - interest rate - at your disposal and currency defences are widely thought to be ineffective at best (as in the case of England, 1992) and ruinous (Indonesia & Malayasia, 1997) at worst. Combine that with the hypothesized effectiveness of the Taylor Rule in combating stagflation, and we seem to have a no-brainer: open capital account completely, let the currency fluctuate and manage the price level through inflation targeting. Broadly, this makes complete sense. However, there are important nuances that are probably being missed out in such a simplified narrative.

For one, emerging market currencies tend to be strongly correlated with all other asset markets in the country. Most capital inflow into emerging markets is on the basis of perceptions of macroeconomic and political risks and stability. In India, the situation is further complicated by the fact that foreign institutional investors are not allowed to buy and sell rupees in the spot (cash) market, unless it is for the explicit purpose of buying equities or some other assets. Now anyone who has any knowldge of trading desks will tell you that such correlations are often speculated on, or other speculations are often based upon assumptions of such correlations. In a crisis, when there is sudden asset deleveraging, such speculations can form a strong postive feedback looop, further aggravating the deleveraging. It is futile to try to establish the cause and effect chain in such feedback cycles - to counter them, one or both the legs of the cycle may be attacked, and this could be the fx market or the correlated asset market (equity, for example). It is interesting to note that the darling of the free market, Hong Kong, had managed to avert the 1997 crisis to a great extent through such operations. The nature of the operations may be different for an economy like India, for the degree and even the direction of the correlations may run different, but point is - it is possible and perhaps desirable to defend a currency provided one does so judiciously. And without discretionary monetary policy, such actions are impossible.

What of inflation targeting? Though the evidence has been mixed, IT gives a robust way to achieve price stability, which is key in an economy with fiat currency, fractional resevrve banking and credit. The question is not whether IT is a worthy goal - it surely is. The question is - should IT be the only focus of the central bank, or are there other objectives just as worthy? Specifically, should the central bank pro-actively intervene in asset price bubbles? This paper by Janet Yellen (governor of Federal Reserve of SSan Francisco and one of the economists touted as Bernanke's successor) discusses the issue in great detail. Yellen notes that not all asset price fluctuations are created equal and broadly says that while equity market booms and busts may be left alone, credit markets deserve a deeper look as credit is the main mechanism of transmission between the financial and the real economy. In either case, praising and echoing Minsky, she emphasizes the need to bring the financial sector and financial stability as explicit constructs in macroeconomics and monetary policy.

Next, what about capital account liberalization? Let's treat the restrictions on corporate debt investments later. First, let's recall what exactly is forbidden in the Indian currency market - FIIs are not allowed to speculate on the spot value of the rupee. They can buy and sell NDFs (non-deliverable forwards) though, and these are short-dated enough to be considered close proxies for the spot market by most trading desks. What this ensures, however, is that the very short term rupee liquidity in the market is insulated from manpulation, allowing RBI greater room to act as a manipulator itself. Raghuram Rajan, whose committee has recommended full capital account convertibility, himself finds in this paper that

Cross-country regressions suggest little connection from foreign capital inflows to more rapid economic growth for developing countries and emerging markets. This suggests that the lack of domestic savings is not the primary constraint on growth in these economies, as implicitly assumed in the benchmark neoclassical framework.

and goes on to suggest a 'pragmatic' way for the process of capital account liberalization. In another paper, he and his co-authors conclude that

even successful developing countries have limited absorptive capacity for foreign resources, either because their financial markets are underdeveloped, or because their economies are prone to overvaluation caused by rapid capital inflows.

seemingly confirming some of the common sensical arguments around the 'hot money' of capital inflows.

Now finally, we turn to the recent critiques that Dr. Shah and Dr. Patnaik have dished out to the RBI. Dr. Patnaik asserts that India is not the only country that has remained relatively unscathed in the crisis and hence there is no evidence that RBI has done a spectacular job and that the world has nothing to learn from RBI. She criticizes the self-praise that some recent RBI establishment people have heaped upon themselves (perhaps Dr. Y V Reddy) and points to the micro and macro-prudential frameworks of east Asia as being worthy of emulation. She concludes memorably

A villager with no roads may foolishly boast of having no accidents, but he cannot teach people how to regulate traffic on busy intersections. It is important for policy makers to remember that India has no lessons to offer to regulators operating in the sophisticated world of finance, and proposals suggesting that they should learn our style of regulation only makes us look foolish.

Let's take a look at what RBI and Dr. Reddy have praised themselves for. This NY Times article provides a clue.

One of the first moves he made was to ban the use of bank loans for the purchase of raw land, which was skyrocketing. Only when the developer was about to commence building could the bank get involved — and then only to make construction loans.

...

Then, as securitizations and derivatives gained increasing prominence in the world’s financial system, the Reserve Bank of India sharply curtailed their use in the country. When Mr. Reddy saw American banks setting up off-balance-sheet vehicles to hide debt, he essentially banned them in India. As a result, banks in India wound up holding onto the loans they made to customers. On the one hand, this meant they made fewer loans than their American counterparts because they couldn’t sell off the loans to Wall Street in securitizations. On the other hand, it meant they still had the incentive — as American banks did not — to see those loans paid back.

Seeing inflation on the horizon, Mr. Reddy pushed interest rates up to more than 20 percent, which of course dampened the housing frenzy. He increased risk weightings on commercial buildings and shopping mall construction, doubling the amount of capital banks were required to hold in reserve in case things went awry. He made banks put aside extra capital for every loan they made. In effect, Mr. Reddy was creating liquidity even before there was a global liquidity crisis.

Now, if these aren't micro and macro-prudential measures, I don't know what are. I fail to see why Dr. Patnaik feels that these measures are something that no one can learn from. Interestingly, Yellen also notes that a way for central banks to induce financial stability is to manage liquidity requirements

Capital requirements could serve as a key tool of macro-prudential supervision. Most proposals for regulatory reform would impose higher capital requirements on systemically important institutions and also design them to vary in a procyclical manner. In other words, capital requirements would rise in economic upswings, so that institutions would build strength in good times, and they would fall in recessions. This pattern would counteract the natural tendency of leverage to amplify business cycle swings—serving as a kind of “automatic stabilizer” for the financial system."

Now compare this with D V Subba Rao's speech, the one that has come under fire from Dr. Shah. Subba Rao, outlining the measures that the RBI recommends to stave the crisis, says

24. It may be relevant to highlight some of the specific features of our system that have contributed to financial stability:

• Banks are required to hold a minimum percentage of their liabilities in risk free government securities under the statutory liquidity ratio (SLR) system. This stipulation ensures that banks are buffered by liquidity in times of stress.

• We managed the capital account actively. In the face of large capital inflows during 2006-08, we sterilised the resultant excess liquidity through calibrated hikes in the cash reserve ratio (CRR) and issue of market stabilisation scheme (MSS) securities. When the flows reversed during the last quarter of 2008, we reversed the measures too. We cut the CRR and bought back the MSS securities to inject liquidity into the banking system.

Seems like Subba Rao and teh RBI, through design or default, have integrated Minsky and Yellen's insight into the system already. He also outlines the fundamental philosophy of RBI's monetray policy and management

20. In contrast to the minimalist formula of ‘single objective, single instrument’, the conduct of monetary policy by the Reserve Bank has been guided by multiple objectives and multiple instruments. In general, our three main objectives have been price stability, growth and financial stability, with the inter se priority among the objectives shifting from time to time depending on the macroeconomic circumstances.

The RBI's philosophy then, is nothing more than what Minsky suggests in his financial instability hypothesis. It is ahead of its time in explicitly recognizing the importance of financial stability as a goal beyond price stability, though I consider Yellen's skepticism about central bank intervention in asset price bubbles healthier than Subba Rao's conviction.

By stark contrast, Dr. Shah's and Dr. Patnaik's op-eds seem like rants that assert what they want to argue. They smirk at RBI's gloating, but this is what Subba Rao says

Sure, we have been hurt by the crisis, but much less than most others. It will be a folly though to let that lull us into complacency and to believe that there is something inevitable about India’s financial stability.

Now let's be charitable and remove all the smirking and rhetoric in the op-eds and look at RBI's philosophy on the main issues - capital account liberalization, financial sector regulation, inflation targeting and currency defence. The RBI has a medium term inflation target of 5% and intervenes in the fx market only when there is "excess volatility'. RBI let the rupee fall from 40 to 52 against the dollar in the crisis, intervening only in most difficult phases. Fx reserves have not been depleted by any significant amount, and as Prof. J R Varma points out, the sterilizing of capital inflows that RBI did during the boom years meant that it was long US treasuries and short Indian equity, an immensely profitable trade in 2008. And this is what DVS says about the capital account liberalization process

We view capital account liberalisation as a process and not an event.

Indeed, this resonates with Rajan's paper. Where the RBI has really been messing up is the regulation of the corporate debt market, which irrespective of its relation to economic growth, is a trade that loses India lots of money, pointed out by Prof. Varma in the same post. This is also the ground on which Subba Rao's integration of financial stability into monetary policy objectives seems the weakest

The policy framework encourages equity flows, especially direct investment flows but debt flows are subject to restrictions which are reviewed and fine-tuned periodically.

If Dr. Shah and Dr. Patnaik were to restrict their critiques of the RBI on this account, and in a juicier more content-filled manner, one would feel bound to agree with them. However, they dilute their strong arguments with a plethora of weak ones, and rather than show some effects of the stunting of the corporate debt market (as Prof. Varma does), take potshots at the RBI's 'gloating'.

This is a classic policy debate situation. The central argument that Dr. Shah espouses is made to look weaker than it is by his undercooked takedown of his intellectual opponent.

Hinduism and I, part 1

In the previous post, I offered four examples, all drawn from people I know, of how different people can have different ways of interpreting 'Hindu', unable to understand which ones Kupamanduka would be willing to include in the fold. My own thoughts on Hinduism are perhaps in order. Disclaimer : this is going to be long, personal and nostalgic. If you lose interest in between due to the egocentricity, my apologies. 

I don't know what deeply religious exactly is, but you could say my family is deeply religious, or at least, they have become deeply religious as time has progressed. My parents both pray everyday, my mother for almost an hour. (The Sundarkaand of the Ramcharitmanas takes time, you know). Now parents always have this urge to ensure that the virtues they picked up anytime in their adult life be imbibed in their children at the earliest. That, coupled with the fact that I have a terribly sticky memory, meant that I was also doing pooja and reciting the Hanuman Chalisa, a few selected verses from the Ramrakhsa Stotra and the most popular hymns to Shivji, Durga and Saraswati by the time I was about 4. Though the reigning deities in my home are Ram, Krishna & Hanuman, I somehow always found the knotted-haired, earthly Shivji very interesting. 

After some initial dabbling with Amar Chitra Katha versions, I had read the Ramayana and the Mahabharata, in Hindi, by the time I was 6. Of course, I did not read all of it, and of course I did not understand and grasp the import of the entire stories. In Mahabharata, for example, I would skip straight to the war after the initial background to the enmity between the Pandavas and the Kauravas had been established. I remember finding Mahabharata a lot more interesting than Ramayana, and when I went back to the epics a few years later (mid 90s) I remember wondering about the plausibility (or lack thereof) of things like the Brahmastra, an army of monkeys, a man with 10 heads, virgin births through the power of prayer and also about the ethics of Rama banishing Sita into exile on the hearsay of a deviant dhobi. The exalted status of Rama and Krishna in normal Hindu religious life and the non-committal idea of an 'avatar' also confounded me. Do bear in mind that I had yet to interact with or be brainwashed by the 'pseudo-secular' media ad intelligentsia - I guess a sense of the history of science and the prevailing common sense morality ofthe society around me were corrupting enough to breed a strong sense of skepticism. 

In the 9th standard, I was intoduced to the Aryan Invasion Theory, which shook my confused understanding of Hindu historicity and mythology even further.  I couldn't swallow it whole though, for I refused to accept that a story as elaborate as the Mahabharata didn't mention a merit in the discusison on the ancient history of India. Around the same time, I discovered that I was more interested in cricket, statistics and girls than in sitting and praying for 10 minutes everyday. I also started wondering about Karma and re-birth at about the same time. I had the good fortune of studying in a school run by the Bharatiya Vidya Bhavan trust. The trust was founded by K M Munshi, renowned freedom fighter, educationists and translator of religious texts. The school attempted to combine the British boarding school concept with the modern academic, scientific orientation and a commitment to the Indian and Hindu philosophies at the same time. One of the ays in which this balance manifested itself was Sanskrit classes from std. 6th to 8th, which consisted of basic gramar lessons followed by recitation of verses from the Bhagwad Gita in a metre, rhythm and style seen commonly in temples of the south. We didn't reach the last chapters, or cover the entire book, but we did cover suitable large portions of it. I remember being dissatisfied with the 'Karmanyevadhikarastu...' philosophy even then. This was definitely the begining of a new intellectual take I had developed on all things big and small, including religion and Hinduism. 

Through 11th and 12th, I independently arrived at a 'first cause' defence of a belief in god. By this time, I had also become convinced that historical stories that were exaggerated by poets, priests and simple-minded devotees became mythologies, and that gods were either nature symbols or kings, or most likely, kings who had adopted nature symbols as their mascots or sources of strength. I also realised that many of the apparent contradictions in Hinduism and the Hindu beliefs are simply because there is no one definite book, prophet or origin of the religion. With a long, ancient and distributed lineage and an active approach to metaphysical and ethical inquiry, differing and competing views on what the world and the universe is and how to live your life are bound to come up. And I was extremely glad for that. But, my approach to religion had already become increasingly philosophical and intellectual and I did not really feel like taking much time out for praying.

In college, I furiously debated God, on the side of believers, against atheist friends. But that is tangential. I also read A L Basham's 'The Wonder That Was India'. Now Basham has his flaws, including a staunch belief in the Aryan Invasion Theory. But the largest section in this book consisted of his explorations of the religious philosophies of the Dharmic religions, especially Hinduism. I was absolutely hooked, and used to spend days poring and deliberating over the mass of information contained in that one section. (This was also the beginning of a somewhat strange habit of underlining, highlighting or bracketing sections in non-academic books with my thoughts and chess-inspired notes of ! and ? written in the margins) That, and Wikipedia, have also opened the door to quantum mechanics and Advaita Vedanta. 

At the same time, I have developed an aversion to some of the more common ways of practising Hinduism, in my own hoouse and elsewhere. For one, I have a strong distaste for Brahmanical rituals like havans. I think it began with an innocuous dislike of fire and smoke, but I still used to take some kind of strange pride in things like knowing the correct way to do swaha (You have to hold the homa on the palm between the middle and ring fingers, and flick it straight with the thumb. The index and the pinky are extended lower and outwards, in an upturned and modified Metallica kind of way). 

No longer. I am almost convinced now that the main techniques of the priest class in any relogion whatsoever, apart from soothsaying (which is good), are shame, guilt and fear. For example, the grihapravesh of my new house was a few months back. Among the many rituals that were done, one was to rid ourselves of the sin of destroying life in the process of building the house (say by destroying weeds on the plot of land or crushing ants through walking on them while constructing/overlooking the construction). So how could we rid ourselves of the sin? How else but by dropping some water here and there and by giving the main priest  some gold, today substitued by cash - the priests have also moved to fiat currency from the gold standard. Mind you, this was for one rite, not for the entire ceremony. Such brokerage charges and commission reminded me of investment banking, with all the inbuilt perverse incentives and more.  

Apart from priestly rituals, I also find myself irritated by the exaltation of every single virtuous character in the epics to a para-human status by devout Hindus. Yes, our minds are simple, but do they really have to be so simplistic? Kunti served sage Durvasa for a year, and he blessed her with a' mantra' that mistakenly gave her a child from the sun-god. Hello, take the hint. At least, don't get offended when others take the hint and say so. What's the point in taking this Christian virgin-birth morality and applying it to either our time or the Mahabharata time?  

Having said that, I admire the prayer-based indiviudal relationships with the supreme that many devout Hindus build. For various reasons, I often feel that Shankaracharya was mistaken when he propounded the Gyaan marga as the one to moksha. The ability to go beyond intellectualising the religious and the metaphysical gladdens me, for I seem to have lost it.  

This post is quite long already amd I have not yet spoken about Hindu political unity. That, and other more topical things in part 2. 

On Hinduism

Kupamanduka recently wrote a post that led to an acerbic reply form Ravikiran that led to further dicussion here. In a nutshell, Kupamanduka lamented the irreligiosity ( or at the very least, 'embarassed religiosity' ) of Hindus and asserted that there was nothing wrong with being more religious and more united with your fellow-reliogionists. In particular, he used the example of Islam and Pakistan (or more precisely, used somebody else's example of Islam and Pakistan) in an approving manner, though he made it clear that he doesn't admire Pakistan on the whole. He used parental love as an analogy, and also quoted this from Swami Vivekanada

"Then and then alone you are a Hindu when the very name sends through you
a galvanic shock of strength. Then and then alone you are a Hindu when
every man who bears the name, from any country, speaking our language or
any other language, becomes at once the nearest and dearest to you. Then
and then alone you are a Hindu when the distress of anyone bearing that
name comes to your heart and makes you feel as if your own son were in
distress. Then and then alone you are a Hindu when you will be ready to
bear everything for them."

Ravi took issue with the example of Pakistan, and I agreed whole-heartedly. He went on to theorise that excessive striving for unity is counterproductive, leads to narrow world-views and may even actively lead to disunity. I don't have an opinion on that yet, though I may just end up agreeing with him. Kupamanduka replied with a post that gave a ponderous justification of his stand using Hindu theological/ethical philosophy. Along the way, he wondered why people uninterested in Hinduism even bother about debates like these, dismissed the intersection of atheism and Hinduism as "non-sense" and most probably assumed that I am either unaware or uninterested in Hindu theology/philosophy. 

So let's take this bit by bit. So who is a Hindu, and what is Hinduism? More precisely, on what basis can those who claim to be Hindus do so? Being born in a Hindu household is enough for the Indian legal system, but it does not seem to be enough for Swami Vivekananda and Kupamanduka. They are more concerned with an adult self-concept, a resonance and identification with either certain ideas or a common way of life, beliefs and culture. In the strong form, one also has to resonate not just with the ideas and the way of life, but also with everyone else who holds the same beliefs and practices the same way of life. 

Consider Vievkanada's quote for example. The great man exhorts us to adopt a view of Hindu brotherhood that supercedes territorial boundaries and even a common way of life (language, etc.) Is this not at odds with the modern vitrue of patriotism? No, a cultural nationalist can easily retort. Why? Because according to one view, the identity of India cannot be derived from the modern European nation state alone, but has also to be derived from Hinduism, or at the very least, Dharmic religions. Thus, if you identify as Hindu, you cannot possibly be far removed from 'Indian'. ( I am not attributing to them the reverse implication, mind you). 

Very well then, what is the problem? Well, at this moment, this definition of Hinduism is very political. Indeed, almost any definition that bases itself on a sense of non-intellectual peer-identification is bound to be political. The idea of 'Hindu unity' is thus by definition political. The political nature of unity is even more pronounced in our times, when the chief causes for Hindu anguish are not religious (like the plundering of the Somnath temple by Mahmud of Ghazni, or the Jaziya tax of Aurangzeb) but political (terrorist attacks, preferential treatment of Muslims by certain political parties, 'pseudo-secular, liberal' bias in the media, demographic change in Tripura, Bengal and Assam through illegal immigration from Bangladesh, distortion of History textbooks by leftist intellectuals).

Now, there's absolutely nothing wrong with a sense of political unity - the trouble comes when one tries to locate the basis of a political identity in philosophical inquiry. The trouble arises when an analogy is made with parental love, ignoring basic evolutionary biology. The trouble arises when Swami  Vivekananda asks us to ignore geographic boundaries, which are the main source of political unity as they are the least suboptimal proxies for shared interests of utility. Most generally, the trouble arises when one constantly shifts from a reliogious/theological perspective of Hinduism to an intellectual/philosophical one to an identity/political one as per one's convenience in the argument.  

Kupamanduka wonders about the disinterest in Hinduism, but he never makes it clear what view of a 'Hindu' is he referring to anyway? Take my mother for example. She is deeply religious, in the 'prayer and destiny' sense. She is also a staunch political Hindu, though she will never bother herself with Hindu philosophical thoughts on the absence/ flaws of free will as a justification for a sense of Hindu unity co-existing with an attempt towards universal love (as kupamanduka does). She is also probably unaware of and uninterested in the particular concepts he quotes in that post. Does she qualify? Or take the example of a deeply religious businessman who builds a temple worth a 100 crores, but couldn't care less about the suffering of fellow Hindus. Does he qualify? Take Vinayak Damodar Savarkar, an atheist who has even publicly lectured against the existence of God (by most accounts, though this is disputed) but who was the father of the modern Hindutva movement. Does he qualify? Or take any of a large number of young engineer kids (born in Hindu families) who are thrilled at the similarities between Advaita Vedanta and quantum mechanics and approach Hinduism through an extremely modern and scientific version of Shankaracharya's Gyan marga. Do they qualify? 

Do notice, that until now, I have only latched on to the main problems in the broader reasoning that he tries to follow. My question about his particular argument of Islam and Pakistan being good exmaples of the unity borne out of religiosity remains over and above these arguments. Kupamanduka says that he will answer this in the next post, so let's wait. 

In the next post, I will clarify my own world-view, my thoughts on the various differing conceptions of 'Hindu' and further outline my problems with the world-view espoused in the Vivekananda quote. 

MBA

I am now a post graduate.

Fundaes-2

Claiming that the faults of big business are not the faults of capitalism is logically and morally equivalent to saying that the faults of big governments are not the faults of communism.

Last I heard, the modern corporation was defined by its system of distributing residual claims and the nature of those claims. Just as socialism is a definite system of governance and socialists should not be blurring it to simply mean anything that desires the greater benefit of the society, capitalism is also a very definite system of ownership and cannot be over-extended to mean just all the good things with the idealised free market. Corporatism is a stupid word.

So, stop with that argument already. It is tautological.

On Economic Thought - 6

From behavioural finance, we move on to behavioural economics. The original and most pervasive idea in behavioural economics is that of bounded rationality. This simply means that contrary to the assumptions of neoclassical economics, human beings are not perfectly rational and often make errors in judgment, though full rationality could be a plausible first cut approximation. We do not optimize economic well-being functions like utility, because we lack the information processing capabilities required to optimize. Instead, we satisfice, i.e. we have certain targets in our mind that we set through a combination of experience, incomplete information and intuition, and then we work towards achieving those targets. We are happy with results that are sub-optimal but still good enough to meet the thresholds that we set for ourselves.

Computer engineers or others with some exposure to the field of artificial intelligence will recognise the difference between optimizing and satisficing to be exactly analogous to the difference between a best-result algorithm and a quickest/computationally easiest good-result heuristic. Thus, the central idea used to move from standard programming to AI is exactly the basis of the move from neoclassical to behavioural economics. It is no surprise then that Herbert Simon, the economist who introduced the idea of bounded rationality, was also a computer scientist. In fact, he is the only person ever to win both the Nobel in economics as well the ACM Turing Medal (possibly the highest recognition in the field of Computer Science). Herb Simon is probably the economist most under-explored by the mainstream, though he finds some pride of place in management literature.

Apart from bounded rationality, behavioural economics also makes some very interesting changes to neoclassical utility theory. Research by Kahneman and Tversky showed that people are not risk-averse, rather they are loss averse, i.e. they place higher weight on the possibility of losing some money as opposed to gaining the same amount. People also measure outcomes relative to some benchmarks that they set for themselves, and a typical example of this is an investor refusing to sell a stock at a loss in a market that is going downwards. Thus, if I have bought a stock at Rs 1000, I will refuse to sell it at 900, even if I believe that tomorrow the price is going to be 800 and rationally, I am better off selling today and holding cash. People value the same thing more once they posses it (status quo bias and endowment effect) and discount future cash flows by inordinately large discount rates (hyperbolic discounting). Importantly, people give different answers to questions that are logically equivalent depending upon the way they have been framed and give logically incorrect answers to seemingly simple rational choice questions if they are posed differently (framing). All this work led to what is known as cumulative prospect theory, which Avataram has sometimes written about. It is essentially an alternative to neoclassical utility theory.

Many of these assertions explain a lot of phenomena that we observe in practice to be near-ubiquitous. The endowment effect results in people demanding higher prices for houses they own than they would be wiling to pay themselves if they were customers, resulting in many unsold houses and reduced liquidity in the real estate market. Hyperbolic discounting means that people systematically err by saving too little for their retirement, something that we see rationalized away in the name of 'living for the moment'. Framing effects imply that people will respond to the exact same information and decision problem differently if the information is unstructured.

Behavioural economics has not only introduced new ideas, its central technique of conducting experiments with people to reveal utility preferences and cognitive biases is also very different from the largely arm-chair approach of mainstream microeconomics. It seems only intuitive that a science that is founded upon assertions of human behaviour follow this approach, but for some strange reason economists of the past have had a disdain for experimentation. The Austrian school was the epitome of such disdain. But more on the Austrian school later.

Back to experiments in economics. Enthused by what I read about behavioural economics, I tried conducting an experiment myself on the relevance of how decision problems are framed.

Consider the following question

There's a red-haired woman who is single. She plays tennis, is a feminist and a member of Greenpeace. What is she more likely to be ?
1) A newsreader
2) A lesbian newsreader

If you answered 2, you'd be in the majority but you'd be wrong. While this may seem to be an effort to illustrate the stereotypes and biases prevalent in society, it is actually nothing of the sort. Bias or no bias, the set of lesbian newsreaders is a subset of the set of all newsreaders. The probability that somebody is a newsreader is thus always greater than or equal to the probability of her being a lesbian newsreader. If you are a rational economic agent who makes the correct choices in decision problems, you would have chosen 1, irrespective of the mass of information presented to you and irrespective of any biases that you may have. However, the vast majority of people across levels of education, political beliefs and geographies pick 2.

I got this simplest of decision problems off something I was reading on the internet, and have posed it to many friends of mine, all MBAs from top institutes in the country. Barring one, every single one of them has given me the wrong answer. One of them (Frust), when offered the solution, suggested that the context matters - had the question been asked in a test measuring his quantitative abilities and knowledge, he might have given the correct answer. Over a dinner table conversation, he faltered. He may very well be right, and that only goes to illustrate the overarching importance of framing - the way and context in which information is presented to you may radically alter your decision. And we all know that real world information and decision choices resemble a dinner-table conversation far more than a probability test.

(You could also use this fact to infer that MBAs are stupid. That conclusion, however, will be dependent on your biases and has nothing to do with such googly-type solutions to decision problems.)

While Herb Simon would count as the big daddy of all behavioural economists, Richard Thaler is the one most prominent now. However, whenever I have read about Keynes and his theories, I have had a sneaking feeling that he may be the original behaviourist. The man who called the stock markets a beauty contest seemed unlikely to be anything else. Indeed, recent research into interpreting his works has followed that path, and the foremost researcher on that front happens to be George Akerlof.

Akerlof won the nobel for his seminal work on information asymmetry, which resulted in the formulation of the adverse selection problem. We don't need to go into the details but suffice it to say that his work introduces the last of the most significant tenets of behavioural economics. Not only are people incapable of processing large amounts of information and prone to multiple cognitive biases, they often do not even have the information rquired to make the requisite optimization or satisficing, and this leads to multiple complications. When this aspect is introduced, even Kenneth Arrow could be counted as a seminal behaviourist. Indeed, his 'learning by doing' model was probably the first endogenous model of growth.

The most interesting thing is that Akerlof has been looking at a theory of 'behavioural macroeconomics' by re-interpreting he works of John Maynard Keynes. He has been among the foremost New Keynesians with his efficiency wages theory that explains how people who get jobs during good times lock in higher-than-equilibrium salaries, and people who look for work during busts have to continue with lower-than-equilibrium salaries even when the times are good. His formal exposition of this intuitive idea has led to considerable new developments on the Phillips curve, the emprically known trade-off between reducing unemployment and reducing inflation. He has also been collaborating with Robert Shiller towards this goal of a theory of behavioural macroeconomics, which can be loosely described as the current New Keynesian macromodel with microfoundations explicitly in behavioural economics. Currently, the microfoundations of the New Keynesian macromodel are largely neoclassical, with a few market imperfections.

From whatever little sense I have been able to make of economics, George Akerlof happens to be my favourite economist. Robert Shiller is another one to watch out for, and let me predict here that he may get the Nobel soon enough, in 2009 or 2010. Shiller correctly called the dot com and the real estate bubbles, but more on him later.

On Economic Thought - 5

Last time, I asserted how financial markets and securities help cut out the tautological subjectivity of value. Well, they go further. The idea of 'rationality' is well defined. 'Efficiency of a market' can be tested sharply because the implication of an 'efficient' market is very objective and can be checked for against market prices. There is a tremendous amount of high quality data available. Finally, even information has some precise definitions in the field of finance.

Among the most celebrated and debated ideas in finance is the efficient market hypothesis (EMH). What does it say? Well simply, that financial markets are rational and hence stocks are fairly priced all the time. In case there is a move away from this ideal equilibrium, it adjusts back to the stable equilibrium state fast enough.

But isn't that absurd? To assume that investors are always rational? Well, that's the catch. The rationality of a market on the whole (or indeed, of the entire economy) has very little to do with the rationality of every individual participant. You see, for the market to be rational, it is not necessary for every, or indeed, even most investors to be rational. All that is needed is that
1) The 'irrationality' is randomly distributed across people and has a mean of zero.
2) There are a reasonable number of 'arbitrageurs' who have the capital and the freedom to make use of those opportunities in the market when stocks are incorrectly priced.

Thus, when Ravikiran asserts here and here that retail investors in India are stupid and hence the EMH may not hold for India, it makes me wonder if he understands the EMH at all. As long as the idiot retail investors in India (or elsewhere) are idiotic in their own randomly distributed ways, the EMH would still hold. The argument is simple - the overestimations of the positive idiots will cancel out the underestimations of the negative idiots. The only problem arises when idiocy is systemic - when idiots make mistakes that are very similar to each other.

Even if the mistakes are systemic, the EMH may not be affected. If there are some few rational people working for a few hedge funds or investment banks who spot these systemic mistakes, they will use their money to capitalize on it to make riskless profits, or arbitrage. These smart guys will make the EMH work by two means
1) The mispricing will correct immediately.
2) If the mispricing does not correct, the arbitrageurs will keep making money and over some time drive out the idiot investors who will be losing their shirts.

Thus, any reasonably mature financial market should be efficient. In this fully developed form, the EMH was among the technically soundest theories to have propped up. It ruled out the efficacy of either technical or fundamental analysis, and implied that your best bet in investing was to buy an index fund, or to passively replicate the benchmark index.

The theory was especially popular in the Chicago School tradition. It fit beautifully with the idea of rational expectations and other such tenets of neoclassical economics. Opposition to this theory has come from various quarters. One of them has been the value investors - the supremely successful stock pickers of the Warren Buffet mould. They rubbish the idea of the market always being fairly priced, buy when things are cheap, sell when they are expensive, and generally make millions doing this. However, it must be noted that they are only aghast at the claim that markets are always efficient. Because, this strategy of buying low and selling high makes money only if prices will someday be correctly priced in. In this manner, the value investor is only performing the role of the rational, efficiency-inducing arbitrageur of the EMH. The value investing school thus quarrels with the more extreme conclusions of the EMH, but has no strong theoretical model to oppose it.

The real challenge to the EMH has come from behavioural finance. Now Avataram probably believes that he has introduced the Indian blogosphere to the existence of Daniel Kahneman, but I stumbled upon these theories while preparing for my summer internship interviews last year. Behavioural finance hit the EMH on its two most important pillars - on the assumption of irrationality being random instead of systemic, and on the assumption of the possibility of profiteering from riskless arbitrage.

Multiple experiments have shown that people across levels of education make choices that are wholly inconsistent with the idea of risk-averse expected utility maximization. The Ellsberg paradox and the Allais paradox are two illustrations of that. More importantly, arbitrage is never truly riskless. There are limits to arbitrage, and the most important one is capital preservation. Arbitrageurs can be driven out of business if the mispricing that they are trying to take advantage of deepens and does not correct as quickly as they'd want to. Their trades will keep losing money, and they run the risk of getting fired for losing money or underperforming their benchmarks. About 50 years before behavioural finance became en vogue, this idea was captured beautifully by Keynes in the quote that I'm sure many have heard - "Markets can stay irrational longer than you can stay solvent". Indeed, if there is one adage that you should know and remember about the financial markets, it is this one. The most striking example of the risk of arbitrage preventing a rational outcome in the markets has been the celebrated case of Royal Dutch and Shell, where stocks of the exact same company split in a 60:40 ratio refused to trade in that ratio for elongated periods of time.

Research into behavioural finance and behavioural economics has over the years produced a rich body of evidence of the systemic cognitive biases that individuals have. The idea of the importance of market microstructre has also gained relevance. I have long believed that if mathematics is at the base of the natural sciences, and philosophy is at the base of the humanities, then psychology is definitely at the base of the social sciences. Since economics is a somwhat scientific social science, I should probably say that cognitive science is at the base of all economics. Some of the ideas presented by the behavioural economists are easily among the most compelling arguments on economic activity that I have come across. But more on that later.

On Economic Thought - 4

We spoke of the Neoclassical theory of prices being hit by the New Keynesians. But what exactly is this theory of price? A theory of prices and values is nothing more than an attempt to answer the questions - 'what is this good actually worth?', and 'why should it be worth that much?'. The analysis could be both descriptive (or as economists would like to call it, positive), or judgmental (normative).

When younger, I often wondered why SRK gets Rs. 2 crs for hamming through a steaming pile of rubbish like KKHH, while the guy who builds your house has no place to sleep once he is done building your house. Needless to say, these were just ponderings over the theory of prices and values. A belief that there is some 'true' value of a product or service is a very intuitive thought and is known as the intrinsic theory of value. In this case, the price of the good may be very different from its perceived value. This belief has a normative bias, for it asserts what a good should be worth, and thus lends itself very easily to adjectives like 'overpriced', 'too cheap', 'unjustified' and 'exploitative'.

On the other hand, the belief that a product or service is worth whatever its user is willing to pay for it is called the subjective theory of value. It thus converges the theory of value and the theory of prices into one. This idea is also known as utility theory and came to the forefront during the marginalist revolution, which is more or less the genesis of neoclassical economics as we know it today. It is somewhat unintuitive, and the fact that it can escape common intuition is one of the main reasons why people are often unwilling to place faith in the market system. It is also ostensibly descriptive in nature - it doesn't say what goods should be worth, just explains why they are priced the way they are.

Before the neoclassicals came along, there were, unsurprisingly, classical economists. I believe that there are three main strains of classical economics, i.e economics of the 18th and 19th centuries. The fountainheads of these strains are Adam Smith, David Ricardo and Karl Marx respectively. One could argue about this point forever, but let's accept the current categorisation as an easy rule of thumb. All three strains have similar, yet subtly different theories of value. They are similar in the sense that all three believed in the intrinsic theory of value. However, while Adam Smith proposed that the 'natural price' of a good is its cost of production, Marx asserted that the true value of a good should be the amount of labour that goes into producing it. Ricardo's ideas were somewhere in between, and he believed that while the labour theory of value is inherently wrong, it can serve as a good approximation. All three agreed, of course, on the fact that market prices can be widely different from this intrinsic value. However, while Smith believed that prices would tend to converge to the intrinsic value, Marx saw the difference between market prices and intrinsic values as another fault of the capitalist system.

Marx, of course, was uneasy with the importance of capital in the first place. But Smith was vindicated to an extent later when neoclassical economists showed that in a competitive market, prices should converge to the cost, albeit the marginal cost. Ricardo's ideas were resurrected later by Pierro Sraffa, but more on Sraffa and his followers later.

The neoclassical idea of the utility theory of value is an extremely powerful concept. However, I think that its claim of being descriptive and not judgmental is somewhat misplaced. If you make the ideas of price and value converge by asserting that a good is worth whatever its user is willing to pay, you are indulging in a tautology. The normative bias in this idea is the inbuilt implication that nothing is ever mispriced. The argument then becomes circular.

This is where the financial markets come in. Unlike, say a shirt, a stock is difficult to fall in love with. The idea of subjective values hardly makes sense when one talks of financial instruments. Thus, while the market price of a financial instrument is dependent upon the actual demand and supply, it is possible to arrive at a 'true intrinsic value' on the basis of a theoretically consistent system of valuation. This true value may differ, sometimes widely, from the market price and thus the financial markets provide a brilliant opportunity to test many of the assumptions and conclusions of neoclassical economics, including rationality and efficiency of markets and market participants. But more on the the financial markets later.

On Economic Thought - 3

So, I happen to be excited about the New Keynesians these days. But before we latch on to the New Keynesians, a little background on Keynesians themselves may be in order.

Everyone has heard of John Maynard Keynes. But what many people do not know or realise is, none of the Keynesian macroeconomic models that economists quibble and debate about ad-infinitum were actually drawn by him. The IS/LM was formalised by John Hicks and Alvin Hansen. The Phillips curve, of course, came later. Keynes himself, wrote his magnum opus and a few other books, debated with intellectual rivals, and became a policy adviser. But much of post World War 2 macroeconomics was dominated by his thought, or more precisely, by various interpretations of his thought. If there is a single important takeaway from Keynesian economics, it is that government policy has the ability to manage aggregate demand (of goods, money and labour) and that demand is the key factor, supply will adjust. This is in opposition to the Neoclassical (or Classical, as Keynes chose to call it) view of aggregate supply being the key factor. The government could manage this demand through deficit spending or interest rates. Thus, it affords ample scope for both monetary and fiscal policy, though the reconstruction efforts after the Great Depression and after World War 2 largely focussed on fiscal initiatives.

The standard textbook interpretation of Keynes is what is called Neo-Keynesian macroeconomics. Paul Samuelson, Robert Solow, Franco Modigliani, John Hicks and James Tobin are probably the most important figures of Neo-Keynesian economics. At its core, it is a marriage of the Neoclassical macromodel of old to the insights from Keynes's opposition to it. Crudely, economists agreed that Keynesian insights were more relevant in the short-run, while the Neoclassical model held in the long run. Whenever assertions about human behaviour had to be made, the Neo-Keynesians turned to standard Neo-Classical microeconomics. In fact, on some important counts (growth theory, for example) Neo-Keynesian macroeconomics had almost nothing to do with the original Keynesian theory. Thus, there was a synthesis of the Neoclassical and the Neo-Keynesian view of markets and the economy. This combination is what introductory courses in economics at most places teach. It is also the academic thought underpinning mainstream right-of-centre capitalism, which supports freedom and efficiency at the individual market level, while allowing an important role for government intervention when dealing with aggregate variables and special situations.

The problem with this synthesis is, it can sometimes be ad-hoc and inconsistent. It talks of microeconomics when it wants to, else it ignores microfoundations. More pertinently, some of the Keynesian conclusions that it draws are logically at contradiction with the assumption of rationality in neoclassical economics. Plus, the demand boosting goverment initiatives that neo-Keynesians speak of are typically inflationary. The stagflation of the early 70's called into question the implied positive correlation between inflation and economic growth.

New Classical Economics arose as a result of these inconsistencies. Robert Lucas and Thomas Sargent insisted that macromodels be formed on grounds that are consistent with microeconomic foundations. They emphasised rational choice, rational expectations and real business cycles. They arrived at some pretty unbelievable conclusions, including one that crudely put, asserts that unemployment is always voluntary. In their view, in a recession, people are basically taking a vacation. There was bound to be some academic backlash to these outlandish theories. Enter the New Keynesians.

The New Keynesians tried to integrate most of the tenets of Keynesian, or neo-Keynesian economics with the neoclassical microfoundations, making room for some more market imperfections than traditional neoclassical economics allowed, while still allowing people to be rational in the long run (Actually, the idea of 'rationality' needs to explored in greater detail, but more on that later).

The details can be left for the serious academic, but one feature of New Keynesian economics (other than DSGE) needs to be talked about. The single most consequential market imperfection that the New Keynesians introduce is the idea of 'sticky' wages and prices. In short, this is the theory that when there is a supply-demand mismatch, it is the quantity rather than the prices that change. Neoclassical theory argues that if for some reason the supply of some product exceeds its demand, its price will drop, and there will be a supply-demand equilibrium at the new price. New Keynesians argues that these hardly happens in practice, and that it is much more common for the suppliers to re-adjust their supply, keeping the prices at their original level. This downward 'stickiness' of prices can be due to a multitude of reasons, from psychological resistance against revision of prices to the costs that are incurred in making this revision. Nowhere is this concept more beautifully illustrated than in the real estate market, where sticker prices continue to be the nearly the same though the developers have lost more than half of their market value.

So what's the big deal, you ask? There is a supply-demand equilibrium anyway, right? So where's the imperfection? Well, the informative role of prices is lost. At an elementary level, this is the single biggest takeaway from the idea of sticky wages and prices. Prices may no longer be indicative of true supply and demand scenarios. There could be extended booms and busts. Thus, while accepting most of the tenets of neoclassical microeconomics, it delivers a blow where it matters the most - on the theory of prices. But, more on the theory of prices and values later.

Prominent New Keynesians include Greg Mankiw, Michael Woodford, Jordi Gali, George Akerlof, Stanley Fischer & Olivier Blanchard.

On economic thought - 2

So I mentioned last time that microeconomics involves much less math than macro does. Well, let me make a qualification to that. There is an important field of microeconomics that is very math heavy - general equilibrium theory. Mainstream economics of the past 200 years owes a lot of techniques and terms to physics for its mathematical analysis. The idea of 'equilibrium' is thus deeply embedded in economics. In microeconomics, the most commonly encountered equilibrium is that between the supply and demand of any product or service. This is referred to as a partial equilibrium - it says nothing about the supply demand relations of other products, and how they affect the equilibrium under consideration.

General equilibrium theory refers to the attempt to bring together the equilibria of all or most of the products and services in the marketplace. Its earliest proponent was Leon Walras, followed a little later by Vilfredo Pareto. Both these economists belonged to the 'Lausanne School', and were highly mathematical in their thought and approach. The Walrasian and the Paretian ways differed in some details, and were brought together int a more general, more refined and highly mathematical neoclassical general equilibrium theory by Kenneth Arrow and Gerard Debreu. Dynamic programming, comparative statics - the modern GET has it all. Unsurprisingly, GET is considered tough and beyond the scope of introductory courses. As a result, I have very little exposure to it. Why do I speak of it then?

Well, even though it's categorised under micro, and uses microeconomics techniques and variables, the level of analysis in GET is very macro. Crudely, while macroeconomics typically tries to analyse aggregate variables in the economy from a top-down perspective, GET tries to aggregate them from their microeconomic components. If you're talking about all product markets inside the economy, you are pretty much talking of the entire real economy (assuming a closed economy - no currency transactions). It is not surprising that the first true macroeconomic model was more or less a scaled up general equilibrium model with some additions. Irving Fisher's neoclassical macromodel draws heavily from the mathematics and analysis of Walras. GET thus forms an interesting bridge between micro and macroeconomics, and a refined GET could be considered one legitimate way of looking at economics in an integrated fashion.

The importance of such an integrated approach cannot be over-emphasized. Indeed, the most technically sound and scathing criticism of Keynesian macroeconomics came from Robert Lucas, who insisted that macroeconomic models be necessarily founded upon and consistent with microeconomic foundations. A branch of macroeconomics that arose as a response to this critique is called New Keynesian Economics. Essentially, it tries to provide Keynesian macroeconomics with consistent and complete microeconomic foundations. But more on that later.

The thing I want to highlight now about New Keynesian Economics is, it uses something called a Dynamic Stochastic General Equilibrium. This is a GE model that attempts to remove some of the more central flaws of the Neocalssical GE model. It is dynamic, instead of static. It allows room to make technology endogenous. It models transitions between equilibira as stochastic processes, and hence it must be cool.

Basically, DSGE models are the high point economics has yet reached in general equilibrium theory. I don't know much about DSGE models, but they excite me. And they are only one of the many things that get me excited about New Keynesian Economics.