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The Crank Economist | Full of unscientific assertions, just like a real economist The Crank Economist | Full of unscientific assertions, just like a real economist Essentials Meta Log in Pages Home About the Author Mood Categories Economics Don’t Worry – It’s Only Cyclical Apr 05 2011 Filed In: Economics An important role for an economist is to pacify the masses during economic downturns, assuring them that the hard times of the moment are a purely natural phenomenon, which will correct itself as surely as the sun will rise again. A useful tool for this task is the so-called “business cycle,” which few economists really believe in – at least I hope not – and which buttresses the desirable illusion that economics is governed by predictable, natural laws. “Don’t worry about current unemployment,” we say with a pat on the head, “since this is only cyclical, not structural.” It’s supposed to be reassuring if jobs are unavailable for cyclical reasons, because cycles are destined to return to their previous peak, right? In our idealized fiction of a business cycle, peak growth is followed by a period of a decrease in growth, then an outright decline in productivity. If the decline is brief we call it a recession, and if it is prolonged we call it a depression. These mild-sounding terms we’ve invented are vast improvements over the old terms “panic” or “bust”. They not only sound better, but they can also be applied to any sort of decline, whether it is abrupt or gradual. This lull in productivity is then replaced by another period of growth, completing the cycle. If this looks cyclical, you might be an economist. Now, unless the world economy enters a period of unending growth or unending decline (or eternal equilibrium, for that matter), it is axiomatic that every period of decline will eventually be followed by a period of growth, and vice versa. This makes the notion of a business cycle especially useful, since it can be made to fit any set of data. The decline could last six months, followed by five years of growth, or vice versa, and we can still call it a cycle. In fact we can discern cycles in virtually any squiggly line, as can be seen from the chart of historical GDP growth shown. Economists have not been able to come to any sort of agreement on what causes business cycles, for much the same reason we can’t agree on what causes unicorns to attack leprechauns. We can often assess the causes of a particular market bust, such as an irrationally speculative overvaluation of assets, or an unanticipated drop in demand. Yet finding general rules to explain full cycles is problematic, since the next period of growth may have causes unrelated to what caused the last bust, I mean recession. That looks better, doesn't it? Those frank enough to admit that business cycles are not cyclical (much as most economic activity is not economical) may use the term ‘fluctuation’ instead. They may even choose to define “growth” and “decline” relative to some mean. This way the chart looks more balanced from peak to trough, and it looks like we’re dealing with some intelligible natural phenomenon, rather than a bunch of disparate crises and recoveries. It’s arguably preferable to maintain that business cycles – or fluctuations, if you prefer – are simply intrinsic to the nature of a market economy. Otherwise, we’ll seem like idiots for not being able to prevent them. The notion of a business cycle has no more informative content than, “Sometimes the economy gets better, and sometimes it gets worse.” So when we say that job losses are “cyclical”, we really just mean that they’re related to an overall decline in economic activity. This is contrasted with “structural” unemployment, which is related to shifts in job creation from one sector to another, so there’s basically a mismatch of talent and job openings. Those who believe that recessions and depressions are caused by declines in demand (refer to the supply and demand fairytale) will say that “cyclical” unemployment is caused by a lull in general demand, and will return to normal with the next big upswing. The problem with this account is that we have no reliable way of predicting how long it will take for the next growth period to arrive. It is also emphatically not the case that economic growth always leads to lower unemployment. Businesses might be able to grow with fewer employees due to general improvements in productivity. “Productivity,” by the way, is just the amount of production you squeeze out of each worker. If you make an employee work 44 hours instead of 40, you’ve improved productivity 10%. When there’s structural unemployment, at least there’s something you can do about it, namely acquire the new skill sets that are currently in demand. With cyclical unemployment, on the other hand, there’s not much hope other than to wait out the cycle. You can see now why it’s helpful to get people to think of things in cyclical terms. Without that promise of inevitable improvement just around the corner, you could have an angry mob on your hands. That would be bad for productivity. Back to Top | Comments Off on Don’t Worry – It’s Only Cyclical Tags: Buy Gold! From Me! (Part 2 of 2) Nov 10 2010 Filed In: Economics By the early twentieth century, the Great Khan’s alchemy of turning paper into wealth had arisen in a new form, as national governments now regularly issued paper bank notes that were backed by national gold reserves. You may ask, how was this really alchemy, if the money was backed by gold? Like the commercial banks of the 17th and 18th centuries, modern governments realized it was necessary to keep only a small fraction of gold reserves in proportion to the amount of notes in circulation, so they effectively had the power to create money with a printing press. Still, this was not true fiat currency, since you could at least, in theory and in practice, demand physical gold in exchange for national bank notes. A one billion mark note. Some countries, due to extreme need or lack of fiscal discipline, issued pure fiat currency not backed by anything. Germany was forced to detach the mark from gold in 1914 due to WWI, and in the early 20s the Weimar Republic irresponsibly issued copious bank notes that soon proved worthless. Several other European countries also learned the joys of hyperinflation. Britain and the United States, by contrast, with vast gold reserves, were able to keep pace with the need for more currency without monetary inflation. When the Great Depression hit, many investors fled to holdings in gold as coins, bullion, or certificates. They increasingly demanded gold in exchange for the national currency, leading Britain to abandon the gold standard in 1931. The United States followed suit in 1933, with the Gold Hoarding Act. “Hoarding” was defined very broadly: you couldn’t own more than $100 in gold coins and certificates, nor could you demand payment in gold by contract. Practically all gold in the United States, save that used for jewelry or industry, was either confiscated or hidden in foreign banks. Now there was only one hoard of gold, held by the U.S. government. Although paper currency was still backed by gold, no one could ever actually claim their gold in exchange for the paper. Since the U.S. government now held a monopoly on monetary gold, it could deliver the coup de grace in 1934, when it decreed that the treasury’s gold would be priced at $35 an ounce, though the dollar had been worth $20.67 an ounce a year earlier, and this was the price at which the government bought up gold. What, unfair you say? So what are you gonna do about it? I thought so. The value of the dollar in terms of gold remained fixed at $35 an ounce all the way through 1971. This effectively made dollars as good as gold notes, as far as foreign investors were concerned. Under the Bretton Woods agreement after World War II, the United States agreed to maintain the convertibility of the dollar into gold, in order to become the world’s reserve currency, while other nations would peg their currency’s value against the dollar, and buy and sell dollars in order to keep the exchange rates fixed. The cost of the Vietnam War and LBJ’s Great Society programs made the $35 an ounce price ridiculously untenable. Dollars were really worth far less, as the government printed them like crazy, but they still had to sell their gold at what was now a ludicrously cheap price. "No one out-weasels Dick Nixon!" The U.S. urged other nations to hold their gold notes, but they insisted on redeeming their paper for gold. The European nations, for their part, were sick of having to buy dollars in order to maintain fixed exchange rates, so West Germany pulled out of Bretton Woods in 1971. In August of that year, not to be outdone, Richard Nixon unilaterally ended the gold standard for the dollar, effectively taking the rest of the world off of the gold standard as well. Within a few years, the fixed exchange rate agreements were replaced by floating exchange rates. In other words, rates were decided by whatever currency traders felt like trading them at. Currency is just another item to be traded and speculated in, like stock. Recall that the U.S. dollar became the world’s reserve currency precisely because it was tied to real value in the form of gold. With the termination of the gold standard, the dollar was still held as a reserve – i.e., as if it were gold – but now the government was free to print as much “gold” as it wants. The Great Khan’s alchemy is now complete. In 1974, Gerald Ford legalized the ownership of gold once again, since it was no longer money and therefore no longer in a position to do harm. Or is it? Gold trades at a much higher price than its metallic worth would indicate. It is usually about half the price of platinum, though platinum is far more rare. This shows that gold is really being traded as money, and of course investors dictate its value. It’s really just another floating currency, except that no government can produce it in arbitrarily large quantities. Nature and human labor control the supply. Gold is used as a storehouse of value when other things like currency, stocks, and bonds seem shaky. Ordinarily we say “cash is king” when securities are money-losers, but when even the strength of the currency is in doubt, we turn to gold. Gold is the one currency whose value is not controlled by any government. Its price fluctuations inversely reflect investor confidence in other currencies, not sudden shifts in confidence in gold. So, when I urge you to buy gold, I’m really asking you to sell the new “gold”, dollars, and buy the old stuff. Why? Because the new stuff is easily devalued: there has been over 1500% inflation since 1933, over 400% since 1971, 67% since 1990. (See Measuring Worth for historical inflation rates before 1900.) Most importantly, the government can screw around with the value of currency as it pleases, but gold’s value is not the slave of anyone’s policy, since the monopoly of ownership in this country was broken by Ford. Now, you aren’t going to make money on gold, unless you speculate on demand-based fluctuations. The point of gold is not to “make” money – it is money, from a time when money wasn’t made out of thin air. Gold is for storing the value you’ve acquired; trading is for acquiring more value. You could also try working, but monetary economists like to discourage that. After all, what do we need to work for if we can create value out of nothing? And before you bring up John Maynard Keynes, let me remind you that he was behind the Bretton Woods system. How’d that turn out for ya? Back to Top | Comments Off on Buy Gold! From Me! (Part 2 of 2) Tags: Buy Gold! From Me! – Part 1 Sep 08 2010 Filed In: Economics No, Mr. Bond, I expect you to float. I wouldn’t be much of a crank economist if I didn’t urge you all to buy gold. Unfortunately, it’s hard for a crank to stand out these days, as even the mainstream advisors are now recommending gold. It’s not that they accept the principle that money should have real value, but gold is only a last resort when paper holdings – stocks, bonds, currencies – are all going south. As soon as the next hint of a bull market comes along, they’ll forget about gold and dismiss us as “goldbugs”. So why doesn’t this faithful asset get more lasting love? It wasn’t always this way. For most of history, gold was the measure and standard of wealth. True, it wasn’t the only form of wealth, nor even the most widely used. In fact, most common people owned little or no currency, and the most widely circulated coins were made of copper, bronze and silver. Still, even poor people knew about gold, and dreamt of it. Metal coins were just a convenient way of transporting wealth, without having to swap ten porcupines for a camel when what you really want is a wombat. The coins had no other use than to be exchanged. They would be imprinted with a royal seal to prove they were of a standard weight, so you could just count coins instead of having to weigh the metal every time you make a transaction. Of course, trusting governments to guarantee the value of coins could be dangerous. Some of the later Roman emperors, in order to finance their wars, debased the silver content of the denarius, while keeping the same face value. These cheapened coins were to be accepted as if they were pure silver, simply on the emperor’s say-so. This was arguably an early instance of “fiat” currency, from the Latin, “let it be so”. Still, the emperor had to make the coins mostly silver in order to have any credibility. He couldn’t just hand out leaves or wood and decree that they were silver. It would take many centuries of social progress for people to fall for that one. There was nothing magic about precious metals. They were simply valuable commodities that were easy to transport, and so were ideal to use as a medium of exchange or currency. Some parts of the world used non-metallic currency. In south central Asia, for example, coral was used as currency, since this was also a rare, slowly produced substance that could be easily carried. Although the value of coins was derived from their value as commodities – i.e., the value of the metal – in practice they were not treated as commodities. You didn’t accept gold or silver as payment because you actually needed gold or silver, but because you knew it would be universally accepted as payment for things you did want. Coins were valued as a medium of exchange, not for their intrinsic use-value. Since coins were accepted as payment for virtually every kind of commodity, they effectively became the standard measure of how much other commodities were worth. This is what we now call the “price” of a commodity, which is its value expressed in terms of a currency. Different parts of the world used different currencies, so to do any long distance trading, it was often necessary to exchange currencies, at rates set by moneychangers who took a cut for themselves. Even uncoined precious metals could have variable exchange rates. In parts of the world where gold was scarce, the exchange rate of silver-to-gold might be 10-1, yet in places where it was plentiful and silver was relatively scarce it could be 5-1. An early instance of trying to displace gold and other natural commodities as currency can be found in the 13th-century Mongol Empire. Marco Polo marveled that the Great Khan had unlocked the secrets of alchemy, for he was able to create money out of the pulp produced by worms on mulberry trees. The paper was created by an elaborate, labor-intensive process, and was printed with its official value, which was proportionate to the size of the bill. Here we still see a quaint attachment to the notion that the nominal value of currency should reflect its actual material value. Still, Marco Polo astutely perceived the awesome power of the Khan’s ability to create money at will, albeit laboriously and at a limited rate. What gave this magic potency was that those who refused to accept the Khan’s currency would be put to death. A fitting start to the era of liberation under paper money. Throughout his travelogue, Marco Polo identifies various cities by simply stating that the inhabitants were all idolaters, were subject to the Great Khan and used paper money. The use of paper money, more than anything else, was an indicator of subjection to the Great Khan, for such people were utterly dependent on his sovereignty as the basis of wealth, and at the mercy of his monetary policy. It is perhaps fitting that the first users of paper currency were idolaters, since idolatry involves treating the representation of a god as the god itself. So far, I have been able to speak of money and currency as if they were the same thing, and this was generally the case until the advent of modern banking. I’ll reserve a full discussion for a later post, but suffice it to note that, at first, banks in the 15th-17th centuries were basically safehouses for your gold, which is still most people’s common-sense understanding of a bank. However, since people rarely demanded to have their physical gold in hand, it became increasingly common for banks to issue loans from their reserves, so there were more bank notes circulating than there was gold to redeem. Effectively, there was now more “money” (the sum of all accounts) than gold currency. The system works as long as the bank keeps enough reserves to meet depositors’ demands, and borrowers repay their loans. The bank notes acted as an early form of paper money. By increasing distribution of notes, banks could effectively increase the money supply out of thin air. Now, it would be a while before the governments of Europe got a piece of this action. At the time, they were held hostage by a species of crank economics called mercantilism, which held that each nation should maximize its stockpile of gold. This led to a shortage of gold in English North America, since the mother country was reluctant to export gold to the colonies. American colonists relied on silver currency, including Spanish coins, from which the dollar is derived, and they also settled accounts by trade. Small wonder that establishing a national currency would be considered a mark of freedom. When the French had their revolution, they also sought monetary independence. The main source of wealth in France was land, so the government issued interest-bearing bonds or assignats representing a certain acreage of confiscated Church property. These were so widely distributed that they effectively came to be used as currency. As the suppression of counter-revolution grew expensive, the French decided to take the alchemy of paper money to a new level, issuing cheaply printed assignats in far greater quantities than there was land to back it up. This of course led to currency devaluation and consequent distrust of the currency, devaluing it even further. Once the production of a currency is detached from any value-bearing commodity, its exchange value becomes purely subjective. After its disastrous flirtation with paper currency, France returned to metallic currency in 1797, like the rest of Europe. Banks used paper notes such as cheques to settle accounts, but it was always understood that these were backed with some real wealth in metals, land, or merchandise. Throughout the nineteenth century, paper bank notes were sporadically issued by governments in times of need. In the nineteenth century, more countries followed Britain in adopting a gold standard, which meant that silver currency should be assigned a value in some fixed weight in gold. The assigned value slightly exceeded the value of the silver, in order to discourage melting silver coins into bullion. Thus the gold standard made silver coin a sort of fiat currency. After sniffing poppies, Dorothy decided to abandon the gold standard for greenbacks. When the United States adopted the gold standard in 1873, there was virulent outrage among populists, who argued that this would limit the money supply, and make silver coin susceptible to hoarding by the rich, just like gold. Some wanted to simply return to a bimetallic standard, while others advocated the free coinage of silver, meaning that individuals could bring silver to be coined on demand. “Free silver” was the premise of William Jennings Bryan’s famous “Cross of Gold” speech, which, for all its merits, was about as successful as his role in the “monkey trial”. Bimetallism is alluded to in The Wizard of Oz, where Dorothy wears silver (not ruby) slippers on the yellow brick road. Of course, we know the yellow brick road ends in emerald green, which is where we’ll head in Part 2. Back to Top | Comments Off on Buy Gold! From Me! – Part 1 Tags: Fun with Game Theory – Part 2 Apr 06 2010 Filed In: Economics Some of you may think that, in Part 1 of this post, I was just kidding when I said some scholars really think altruism is reducible to a selfish pursuit of pleasure. Just to prove that I would never deceive my readers, the New York Times ran an article making this exact argument. You really can’t make this stuff up. Uncharacteristically for an economist, I decided to do a little empirical research, so I asked Mrs. Crank: “Do you feel good when you give to charity?” “Yeah.” “So you give to charity in order to feel good?” “No, I give for the greater good, and to help people in need.” “But you feel good when you give, so aren’t you being selfish?” “No, I’m giving to help others.” “But you admit that you feel good when you give, so aren’t you just giving so you can get that good feeling?” “No, the feeling good is just a side effect. It’s not the reason I give. I give to help people.” Apparently, Mrs. Crank understands the distinction between correlation and causality, making her smarter than a lot of behavioral scientists. Cicero believed expediency is subordinate to what is right. He never studied game theory. People often do game-theoretically stupid things. For example, from a game-theoretic perspective, it’s optimal for every soldier to abandon his post during battle, rather than risk being one of the few who remains and is killed. In actual battles, however, this rarely happens. The ignorant might suppose that such a counterexample suggests that soldiers do not reason strictly in terms of utility and payoff. We who are economically educated realize that this proves only that loyalty and courage are irrational, or that we need a broader definition of utility to encompass them. Modeling economics in terms of utilitarian preferences runs into several problems beyond those already discussed. For one, applying game theory to economics is possible only if economic preferences are consistent. This means that if you prefer A over B and B over C, you can’t prefer C over A. Once again, real life doesn’t always work that way. Betting on boxing, I would take Ali over Foreman, and Foreman over Frazier, but I might still rationally pick Frazier over Ali. The pairing of options can alter my preferences. Worse still, my preferences can change arbitrarily from one minute to the next, and in fact billions of dollars are constantly being spent on advertising and marketing to persuade me to alter my preferences. Even if my preferences were constant and well-ordered, I would be unable to quantify my utility, and confidently say, “I like X 2.5 times as much as Y.” Undeterred, economists have come with a scheme to quantify utility, by supposing that an agent would trade 1 X for 2.5 Y‘s, and thus prefers X 2.5 times as much as Y. The hypothetical agent of economic game theory knows exactly how much of each commodity or service he would trade for any other commodity or service, as if he worked out his own fully self-consistent system of value. I know of a mathematically talented Marxist professor who tried for 20 years to develop such a system, without success, causing him to abandon belief in an objective theory of value. Yet economic game theory assumes that each of us intuitively develops our own personal, fully consistent theory of value. We’re all mathematical geniuses and we don’t even know it! Another problem is that game theory must assign quantifiable payoffs to each outcome in order to help us determine the best strategy, but in real life we almost never know what the payoff will be, as this is affected by market forces beyond our control. In fact, our own actions contribute to market forces in ways that will unpredictably alter the payoff. This is why game theory is not used in real life, except in cases where payoffs are fairly well-defined, such as government auctions of utilities. In other scenarios, game theory can be used can be used to rationalize any strategy and its opposite. While this is not helpful for choosing strategies, it does help theorists explain any reality post hoc. Sounds a lot like evolutionary psychology. Armed with a much broader notion of utility, game theory has enjoyed greater success in biology due to the work of John Maynard Smith. In evolutionary game theory, the strategies themselves (phenotypes) are the players, and the successful players will replicate. Evolutionary game theory has a broader notion of equilibrium than Nash equilibrium: an evolutionarily stable state (ESS) need not be the most efficient equilibrium; it only needs to be stable in the dynamic game. Such a stable state can be characterized by a distribution of phenotypes in a population. (It should be noted that game theory doesn’t prove any model of phylogeny; the game-theoretic definition of “evolution” is merely a change in phenotype frequency.) Applied to population biology, Maynard Smith’s version of game theory might explain distributions of animal behaviors, not just physical characteristics. For example, cooperative animals that can identify other cooperators will do better in the long run than rogues who identify other rogues. In this view, most animals in a species are cooperative because it leads to collective success. It’s just a stochastic outcome. It would seem there is no utilitarian reason for animals to care about later generations, except for the fact that generations overlap and there is a need to cooperate with the younger generation. The overlap of generations would make concern for posterity a stable strategy. Yes, you love your children because you need them in order to survive, or at least your ancestors did. Evolutionary psychologists and economists are kindred souls, really. Evolutionary game theory has demonstrated some predictive power in various scenarios in population biology, but it has some important limitations. It works rather poorly when animals are constantly changing their preferences, in which case there is no single family of functions that maximizes utility, and indeed no reliable way to model utility. For physical phenotypes, utility is a measure of adaptive advantage, but there is no reliable way to tell that a particular trait has, say, a 2% survival advantage, since we cannot control for all other traits and a fixed environment. The problem of measuring behavior utility is even worse, especially when they are changing. As with economic game theory, behavioral evolutionary game theory is useful only for rationalizing observed behavior after the fact. The broader definition of equilibrium in evolutionary game theory lets us rationalize just about any behavior and its opposite. Of course, the sheer breadth of valid evolutionarily stable states makes evolutionary game theory useless at distinguishing rational and irrational behaviors. If all dark-haired people decided it’s good to kill blonds, that would be an evolutionarily stable strategy. Evolutionarily stable strategies have included infanticide, rape, and cannibalism, to name a few. Maynard Smith himself tried to explain our sense of fairness in terms of an evolutionary pressure to be fair. In his thought experiment, “Fairmen” sought out other Fairmen, and thereby were motivated to establish justice, as a purely stochastic outcome. Of course, the historical record details the actual establishment of many societies, showing conscious motivations completely unrelated to the evolutionary explanation suggested by game theory. Of course, real scientists know that conscious motivations are bunk, and we actually can only make choices in ways that can be modeled by utility functions. Darn it, I worked hard for my math degree, and I’m going to use it! Human beings are defiant little twerps, clever enough to formulate their own reasons for laws and ideas, and they can even consciously change strategies. Many of them refuse to imitate the strategies of their parents, much less those of their remote ancestors. If they’re really mischievous, they may even behave in an overtly non-utilitarian manner, doing “right” just because it’s right, and not for any payoff. They can deliberately flout the rules of the game. Those of us in the life and economic sciences like to project the appearance of having deep insights into human behavior, even though we often exhibit little understanding of the people around us. Not to worry, however. We can always create hypothetical people who will behave exactly the way we want, and we’ll have the observed utilitarian opportunism of animals to corroborate our theories. Who said economics can’t be scientific? Back to Top | Comments Off on Fun with Game Theory – Part 2 Tags: Fun with Game Theory – Part 1 Jan 11 2010 Filed In: Economics If you think economic theory is a joke, you’re wrong – it’s a game! In this two-part series, you’ll learn the rules of economic game theory, which models how people would act in different scenarios if they all thought like academic economists. This may not help you in business, but it’s useful for designing video games with good computer players, a skill that could come in handy when you’re discredited and out of a job. Economic game theory tells us how rational people ought to behave, where “rational” is defined as trying to obtain an optimal reward or payoff. In game theory, all players are assumed to select behaviors or strategies that will maximize “utility,” an abstract function that could mean wealth, pleasure, desirability, or anything else a creature might maximize. In fact, the concept of utility is vague enough so that a “player” could be a bacterium. Fortunately, most pre-Cambrian lifeforms were able to secure advance copies of the works of Jeremy Bentham and John Stuart Mill. Do unto others before they do unto you. The idea that “reasonable” or “rational” behavior is synonymous with selfishness is not unique to game theory, but has long been a staple of economic and biological theories in the Anglo-American tradition. British and American intellectuals have consistently found nature to be made in the image of classical liberalism. Oh, sure, we acknowledge the existence of altruism and various selfless virtues, but we’ll simply model the desire for altruism as a kind of utility, where you get a psychological payoff or indirect benefit when others do well. In other words, we define everyone to be utilitarian no matter how you act, even if you’re Mother Teresa. Social science has proven that at bottom we’re all upper middle class white people. Game theory was developed by the mathematician John Nash, aka Russell Crowe when he found some time between fighting oily Romans and making Max Baer look like a jerk. Economists love mathematical formalism because we find it difficult to use ordinary language in a logically coherent manner, and we assume that others are equally inept. Mathematical formalism, with its perfect logical consistency, carries an air of authority that discourages people from asking messy questions such as how theory comports with reality. Game theory has all the essential features of sound theoretical economics. It is formal, abstract, comprehensive, and no one actually uses it in business. In Nash’s version of game theory, players try to maximize their payoff by anticipating the possible actions or strategies of other players, who presumably are trying to maximize their own payoffs. When one strategy leads a player to a better payoff regardless of the strategies chosen by other players or any parametric constraints, that strategy is said to “strictly dominate.” Even in games where there is no strictly dominant strategy, there can be what is called a “Nash equilibrium,” a scenario where, once certain strategies have been chosen, no player could improve his payoff by unilaterally changing his strategy, so there is no incentive to do so, making this an equilibrium state. Unfortunately, people don’t generally act in the way game theory predicts. In one experiment made known to Nash, no one played according to Nash equilibrium, even when the players were mathematicians and economists. Nash marveled that educated people could behave so irrationally. A good theoretician knows that if actual behavior contradicts the theory, the behavior must be wrong, not the theory. If physics worked this way, I would have always got perfect marks, since I could impugn the rationality of any particle that behaved differently from what I predicted. Fortunately for economists, human beings are much more likely than electrons to defer to the authority of experts. After playing simple games multiple times, many people begin to exhibit Nash equilibrium behavior, since the payoffs are well-defined and the strategies are easy to figure out through experience and common sense. However, game theory becomes insanely complicated for games that are significantly more sophisticated than Tic-Tac-Toe (or “noughts and crosses”), and it’s doubtful that our subconscious can simulate complex game theoretic calculations. For simple games, game theory only tells us what we could figure out for ourselves through common sense. For more complex games, it may tell us what we should do, but not what we actually do. Strangely, classical game theory is not always able to define what makes a strategy more rational. For example, consider a simple game with two equilibria, one where each person wins $1000 if both choose A, and one where each person wins $100 if both choose B, but neither win anything if they choose differently from each other. In classical game theory, there is no basis for making one equilibrium (both choosing A) preferable to the other (both choosing B), though we all know which we’d prefer. Shrewd gamblers often diverge from game theoretic predictions depending on the stakes. Even if I know I’m better off on average taking a smaller payoff, I might still want to go for the much less probable but larger payoff that could change my life. Of course, you can model this strategy in terms of some higher order payoff, in which case you’re basically just translating common sense from ordinary language into mathematical formalism without adding any new insight. This is highly useful if you actually get paid for that sort of thing; thus game theory maximizes payoffs for theoreticians. In the normal form of the Prisoner’s Dilemma game, where players choose strategies simultaneously, it’s theoretically optimal for both prisoners to confess. In actual experiments, however, many players persistently refuse to confess, out of some irrational feeling such as loyalty or the notion that I shouldn’t do to another what I wouldn’t want done to me, or the crazy hope that the other player will be humane enough to do the same. Nash judged such behavior to be irrational, though strangely it ends up paying off for both players, so it works even by utilitarian standards. In the sequential version of the game, where players do not choose strategies simultaneously, it is advantageous for the first player to betray the other person, but this isn’t what people actually do. Often they both refuse, and get off lightly. The behavior of the second player might be explained as reciprocation rather than pure altruism, but the behavior of the first player seems to defy utilitarianism, unless we broaden the concept of utility to the point of meaninglessness, which is exactly what we’ll attempt in Part 2. Back to Top | 1 Comment Tags: Obama Wins Nobel in Economics Oct 21 2009 Filed In: Economics In a stunning development, U.S. President Barack Obama has been awarded the Nobel Memorial Prize in Economic Sciences, for his “unswerving efforts to rehabilitate the prestige of economists.” The Swedish committee added, “We hope this will encourage Mr. Obama to follow our nation’s path toward an oil-free economy, so we can really stick it to the Norwegians.” "They gave me what?" The White House, apparently surprised by the announcement, released this statement: “While the President is grateful to receive this honor, he has no idea how his name came up. Besides, he understands that the Economics prize isn’t even a real Nobel Prize. Nevertheless, he graciously accepts and will donate the award money to a worthy bank or brokerage in need.” Truth be told, President Obama has been a strenuous advocate of the economic sciences. His Keynesian stimulus package tickled the ego of last year’s laureate Paul Kroogman, who nevertheless complained the spending wasn’t big enough. In theory, the stimulus is supposed to stimulate demand and create jobs, but in fact employment and consumer spending have continued to sag. However, the stimulus has been credited for causing a stock market rebound, in a clever application of post hoc ergo propter hoc, leading to the daring conclusion that Keynes’ policy prescriptions most benefit the financial “casino” he disdained. This discovery alone should merit the Nobel. Mr. Obama has also made substantive contributions to actuarial science. In his famous health care speech, he proposed requiring insurance companies to provide more expansive coverage, with no cap, and no exceptions for previously existing conditions. Flouting conventional actuarial wisdom, he predicted that premiums will actually decrease, if only the non-poor uninsured were paying into the system. This was an especially bold claim, considering that most premiums are rising in Massachusetts, even though their mandatory health insurance is subsidized. Mr. Obama claimed the federal public option would not be subsidized, and so presumably would be subject to the principles of actuarial analysis. His proposal, therefore, constitutes a radical reinterpretation of those principles, using complex variables with a nonzero imaginary component. Less daring souls in Mr. Obama’s party have sought to make the public option sustainable by requiring providers to pay only 5% more than Medicare rates. This way, the public option in the long term will only be slightly less self-sustainable than Medicare, where cost will exceed revenue in the next decade or two. From 1970 to 2007, Medicare costs have increased 8.5% annually per person, while private insurers increased costs 9.7%. Clearly, the problem is with private insurance and not with hospital overcharging or pharmaceutical profiteering, since 8.5% is a completely sustainable rate of increase. Mr. Obama is also being considered for the Milton Friedman Prize for Advancing Liberty, for continuing to allow financial institutions to freely trade in the same credit default swaps and other financial instruments that brought the 2008 crash. However, the President is expected to decline the honor, as hinted by his proposed bill to require some transparency in derivatives trading. Nonetheless, free marketers remain hopeful that this will impose no real inconvenience to major financial institutions. Most notably, Mr. Obama has done more than anyone to burnish the tarnished reputations of mainstream economists, repeatedly defending his policies by citing the support of academics, as if that were an obvious selling point. For this effort, along with his remarkable synthesis of Keynesian socialization of cost and Friedmanian deregulation of finance, he has earned the commendation of economists everywhere. In other news, the Nobel Peace Prize was awarded to Elinor Ostrom, for her work showing that people can cooperate efficiently without recourse to centralized planning or privatization of common property. This correction of mainstream liberal and neoclassical thinking was made possible by the novel approach of observing reality instead of relying on abstract mathematical models. By showing the possibility of efficient economic activity through cooperation rather than coercion or competition, she has provided the conceptual basis for a non-misanthropic social order. Curiously enough, she still resides in the United States. Back to Top | 2 Comments Tags: Supply and Demand: A Fairytale Sep 17 2009 Filed In: Economics Supply and Demand ruled an imaginary kingdom Once upon a time in an imaginary world, where economics was as rigorous as physics, there was a kingdom ruled by Supply and Demand. The king and queen were simple curves who intersected to create an Equilibrium Price, a sweet lad who was the prince of the realm. When Supply rose, the Equilibrium Price would go down, and when Demand rose, the Equilibrium Price would go up. In this magical kingdom, people scrupulously obeyed the law of Supply and Demand, which was to the benefit of everyone. Businesses could measure Demand objectively and reliably, and consumers did not change their price preferences constantly, so a simple price curve could be drawn. After a peak in Demand subsided, they did the honorable thing and immediately lowered prices back to previous levels, as swiftly as they had risen. When Supply was ample, retailers dutifully lowered their prices, rather than try to make large profits on fewer units and dump the rest. Industry leaders never tacitly colluded on prices, but freely engaged in price wars for the benefit of the consumer. Government activity constituted such a minor sector of the economy that its effects could be safely ignored. Despite being filled with economic law-abiding people, the kingdom was threatened with chaos – of the mathematical kind. Since there were more than three commodities and more than three people in the kingdom, it was possible for prices to be in permanent instability. The Equilibrium Price, if he was to live, would at best be a precarious equilibrium. Such was the dread pronouncement of the wizards Sonnenschein, Mantel, and Debreu. They were duly exiled from the kingdom, while the most skillful economists of the land were summoned to show how a careful selection of initial conditions and individual consumer Demand curves might save the law of Supply and Demand, with their precious son, Equilibrium Price. Decades passed, and the threat seemed to have subsided, when a new sorcerer named Donald Saari arose. Using the latest tools of his craft, Saari showed that even if an equilibrium state existed, all one had to do was add one commodity and the system would collapse into an unstable mathematical chaos. This finding held even without specifying anything peculiar about individual Demand functions. An invisible hand guided the kingdom. In order to preserve their rule and the credibility of neoclassical economics, Supply and Demand decreed that no new commodities could be introduced into the economy, nor was anyone allowed to be born or die. Thus the law of Supply and Demand was vindicated, and everyone lived happily ever after. Of course, this is just a fairytale. Economists have known for over 30 years that there is no such thing as an equilibrium price, but the law of supply and demand is a mainstay of economics texts. This nice little bedtime story gives us the warm, fuzzy feeling that economics is a real science grounded in mathematics, and can explain the world with simple formulas just like physics. The kingdom of Supply and Demand may be a fantasy, but the mathematical wizardry is quite real. The SMD theorem proved that stability is not a general feature of markets [PDF], and Saari proved [PDF] that any Walrasian equilibrium would collapse into chaos just by adding a commodity. Unstable chaos is the norm, while general equilibrium is a myth. In reality, prices for some commodities remain relatively stable, simply because people come to have expectations about what is a “fair price.” Medieval economists tried to come up with a theory of the fair price, but modern economists have instead decided to direct our attention to the elusive “equilibrium price,” trying to ground economics in laws of physical necessity, as if there were a “natural” market price. Now that you’re in on the secret, you know as well as any businessman that a thing is worth whatever you can get for it. Back to Top | 3 Comments Tags: Wade Boggs Teaches Economic Stats Aug 12 2009 Filed In: Economics Have you been underemployed or buried in debt at times when the economy was said to be doing well? Have you noticed that many of your peers had similar struggles, even during the big “growth” years of the ’90s? If you’re wondering how it is that macroeconomic statistics often seem so out of step with everyday reality, you need the Wade Boggs Guide to Economic Statistics. Wade Boggs shows the way to success with stats Baseball Hall of Famer Wade Boggs will teach you that winning or losing isn’t what’s important, but having good stats. Why ruin your batting average looking for home runs when you can slap a single into a short left field? The stats are what people will remember in the long run. Applying this philosophy to economics, Boggs shows why you shouldn’t fret about your household finances as long as the stats are good. If the GDP or the Dow is going up, the economy is doing well, by definition. Economics, like baseball, is a numbers game, so we put much more stock in statistics than in subjective judgments about what’s good for people. This 90-minute video shows how economic stats can be boosted, helping people feel better about the economy as they cash their unemployment checks. Companies can improve stock prices by becoming leaner and meaner, cutting employee payroll and benefits, raising prices, and obtaining government subsidies. If smaller businesses fail, there’s no problem, since the market’s stats won’t be affected. Indices like the Dow, the Nasdaq, and S&P take the average values of large, successful companies, so they won’t be dragged down by the bench players. Ordinary Joes will beam with pride as the stock index rises and their 20 shares of Chevron gain $50 value, making it a joy to pay more at the pump. A rising tide lifts all ships, as they say. In the video segment on GDP, you’ll learn tricks for pumping up this important stat, some of them as easy as a cheap double off the wall at Fenway Park. Did you know you could increase GDP by paying someone to dig a hole and then fill it again? All production is good for the economy! Worrying about efficiency is like worrying about situational hitting. Do you really want to ruin your average with sacrifice flies and bunts? Stop saving, and spend and work like crazy! This way there will be more economic activity, and more wealth to enjoy if you ever get some free time (see Part 3: The Joy of Unemployment). Don’t agonize over whether your economic activity is useful or meaningful; just be happy you’re improving your production stats. Since economists use total productivity, without regard for efficiency or quality of life, as the primary measure of economic health, this encourages long work hours, massive consumption, consumer debt, and exhaustion of resources as being good for the economy. We can always blame the bad side effects on the opposing political party. Boggs also shows how to revitalize a slumping industry by spending like a Steinbrenner. For example, you can boost auto sales by paying people $4500 to destroy their existing, fully functioning car and buy a new one. Don’t worry about the waste involved. Remember, the purpose of all economic activity is to maximize production, even if it’s for things we don’t need. Even the Communists understand the spirit of pride in statistics. In order to overtake the U.S. in steel production, Chairman Mao once ordered everyone to make steel. Ordinary Chinese stripped their houses of all metal objects, down to their bedsprings, in order to melt them into steel and meet their quota. Remember, if the production stats are good, the economy is good, by definition. Following these tips, we’ll be on our way to a jobless recovery in no time! We’re offering this video for only $9.99, so we can move more units, even though it’s less profitable to us. Like we say, it’s the stats that matter! Back to Top | 2 Comments Tags: Irrational Expectations Jul 18 2009 Filed In: Economics A central problem in economics is modeling how people make investment decisions, using math complicated enough to impress the masses, yet simple enough for an economist to grasp. If economists are to pose convincingly as scientists, we need to jury-rig a mathematical model of human economic behavior to yield the predicted results of our pet macroeconomic theory. In the old days, most economists simply assumed that people made economic decisions based on their experience, such as the past performance of assets. The problem with modeling based on data from the past is that it would make our prediction claims empirically testable, possibly revealing that there are no natural laws of economics. We obviously can’t have that, and besides, people don’t make decisions based on experience alone. People making investment decisions take into account their expectations of macroeconomic phenomena, such as GDP growth, unemployment, and inflation. If we had a good model of how people form expectations, we could show how our favorite macroeconomic theory follows from it. Then we could explain any apparent failure of our theory in terms of changes in expectations. Here’s where things get tricky. Governments are advised by economists who fully understand the effect of expectations on investor decisions. A smart government could use this knowledge to manipulate expectations by futzing with interest rates and the money supply. These changed expectations will get people to adjust their economic behavior as desired by the government. Further complicating matters, investors aren’t quite that dumb. They too are familiar with current economic wisdom, so they know exactly how the government is trying to shape expectations. If the government announces a spending package to stimulate growth, companies might take this as a sign that bad times are ahead, and shore up their balance sheets. If the government lowers interest rates to encourage lending, financiers might see this as a desperate act, and tighten credit. In other words, being wise to the game, people may actually respond in a way that is opposite to what the government wants and economic theory predicts, which is bad for our credibility. Expectation theory is not circular. You feel sleepy... To salvage mainstream economics, we need to redefine how expectations are formed. In 1961, John Muth suggested “that expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory.” This was sheer brilliance. By assuming that people make forecasts similar to what economic theory predicts, we can create models where the sum of all human decisions tends to the outcomes predicted by economic theory. There is nothing circular or self-fulfilling about this, as proven by the figure on the left. This assumption was naturally called “rational expectations,” since nothing could be more rational than to expect economists’ predictions to be correct. For every bear, there is a CNBC analyst. There are some hitches, however. In order for an investor to make a forecast as good as an economist’s, which is perfect, he needs all available information, not just past performance. If someone should have less than perfect information, his forecast will differ from the perfectly correct answer predicted by economic theory, but only by some random amount. Basically, we assume that people are equally likely to be too bearish or too bullish. We can safely assume that predictions deviate from economic theory only randomly, since there can be no rational basis for disagreeing with economic theory. Besides, systematic error analysis is really hard. We’re economists, not physicists. Although it is grounded in eminently reasonable assumptions, rational expectations modeling has run into some problems. First, even economists can’t agree on a macroeconomic theory, so how are lay investors to know which prophet to follow? Further, how can we expect laymen to predict market equilibrium values, if economists don’t dare to predict them, and may even doubt whether they exist? To address such concerns, I propose supplementing current theory with an assumption of “irrational expectations.” Most investors ignore scholarly economics as they are immersed in the rough-and-tumble world of trading and finance. Real investors try to project market trends based on past performance, company fundamentals, news reports, financial advice, panic, euphoria, hunches and calculated guesses. Decisions can be affected by what CNBC says, how nervous I am, flashy graphics, or what the squiggly line looks like (also known as “technical analysis”). We can also be deliberate contrarians, trying to cash in on what we expect everyone else to do, perhaps by trading options or hedge funds. If we could mathematically model irrational expectations in a way that makes my theoretical prediction correct, job security could be ensured for generations of economists. One possible model could be expressed in this formula: E = T + [(A + 75s) – R + G + N + (D/F) – B](1 – C)IQ E is the average expected price of a commodity or asset in 50 days; T is the theoretically predicted price; A is the 50-day average, s is the slope of the trendline, R is the resemblance of the 1-year trendline to my favorite letter of the alphabet, G measures government bribes and lobbying; N is the net positive news stories; D is the concentration of dopamine in my brain; F is the root mean square of my fear, fidgetiness, and wussiness; B is Jim Cramer’s blood pressure; and C is the fraction of contrarian investors. ‘IQ’ is the intelligence of anyone who buys into this sort of modeling, which is always zero, hence the average expected value should always equal the theoretical value. Back to Top | Comments Off on Irrational Expectations Tags: The Proto Clown Theory of Tax Cuts May 10 2009 Filed In: Economics Clown SMASH taxes! As aficionados of The Tick will know, Proto Clown was an experiment gone awry, based on the misbegotten principle: “If regular clowns are funny, than a really big clown will be even funnier.” The musclebound harlequin went on a steroid-fueled rampage, but despite the personal injury and property damage inflicted, the experiment was vindicated as this was one of the funniest episodes of the first season. In a similarly counterintuitive way, some of the more aggressive supply-siders have reasoned: “If regular tax cuts are good, than a really big tax cut will be even better.” I call this the Proto Clown Theory of Tax Cuts. Anyone who’s played SimCity knows that lowering taxes improves growth, so that you can actually increase revenue by reducing the tax rate. This is because Will Wright is a closet Reaganite, and also because high tax rates drive away residents and businesses. This only works up to a certain point, however. If you go below 6% (4% for commerce), you’re just giving away revenue. This phenomenon of an optimal tax rate was clearly articulated by Arthur Laffer in the 1970s. The principle is sound enough, but controversy arises when trying to determine what the optimal tax rate (t*) should be for a particular place and time. At one extreme, we can consider the possibility that tax cuts will never increase revenue, so the optimal rate t* must be 100%. This makes sense on the national level, at least, since people don’t have the option of moving to Schwinton or Oak Creek to get a lower tax rate. With a captive clientele, governments enjoy monopoly power, so they can charge whatever rate they like. Arguably, this could even stimulate growth, as people will have to work more to maintain the same standard of living. Also, if everyone is heavily taxed, there’s less disposable income, therefore less demand and lower inflation. Terrific! Papa Shango, mastermind of the Bush tax cuts and the Kerry nomination At the other extreme, we have the Proto Clown Theory of Tax Cuts, which says bigger tax cuts are always better, implying that the optimal rate t* is 0%. As George Bush, Sr. realized, this theory is justified by voodoo, a sophisticated science using herbs and other organic materials to make bad things happen to our enemies. The way it works is that we repeatedly cut marginal tax rates for the rich, while claiming that the losses will be compensated by gains in growth. Anyone who opposes us can be characterized as “anti-growth,” which is actually a hex spell that makes the opposition do dumb things like nominate uncharismatic wonks for national office. A variation of the theory is to acknowledge that tax cuts will create deficits, but insist that deficits don’t matter. Like most theses of political economy, the truth of this claim depends on the speaker. If Dick Cheney says it, it is evidence of anti-intellectual sociopathy. If John Maynard Keynes says it, it is a penetrating insight liberating us from the morality of thrift. Optimal taxation is concerned only with maximizing revenue, not with what is fair or just. Economists got out of that business over a century ago; such moralizing is utterly pre-scientific. Taxes ought to be raised or lowered in order to manipulate macroeconomic supply or demand. This is a common ground on which cranks of all political persuasions can agree. Back to Top | Comments Off on The Proto Clown Theory of Tax Cuts Tags: Older Posts ? Shortcuts & Links Search Latest Posts Apr 05 2011 Don’t Worry – It’s Only Cyclical Nov 10 2010 Buy Gold! From Me! (Part 2 of 2) Sep 08 2010 Buy Gold! 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