Sam Vaknin, Ph.D.
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A Narcissus Publications Imprint, Skopje 2003
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Created by: LIDIJA RANGELOVSKA
REPUBLIC OF MACEDONIA
C O N T E N T S
Economics - Psychology's Neglected Branch
The Misconception of Scarcity
The Roller Coaster Market – On Volatility
The Friendly Trend
The Merits of Inflation
The Benefits of Oligopolies
Moral Hazard and the Survival Value of Risk
The Business of Risk
Global Differential Pricing
The Disruptive Engine - Innovation
Governments and Growth
The Distributive Justice of the Market
The Myth of the Earnings Yield
Immortality and Mortality in the Economic Sciences
The Agent-Principal Conundrum
The Green-Eyed Capitalist
The Case of the Compressed Image
The Fabric of Economic Trust
Scavenger Economies, Predator Economies
Notes on the Economics of Game Theory
Knowledge and Power
Market Impeders and Market Inefficiencies
Financial Crises, Global Capital Flows and
the International Financial Architecture
War and the Business Cycle
America’s Current Account Deficit
Anarchy as an Organizing Principle
Narcissism in the Boardroom
Is Education a Public Good?
The Demise of the Work Ethic
Foreign Direct Investment (FDI) – Pros and Cons
The Economics of Expectations
Corruption and Transparency
Workaholism, Leisure, and Pleasure
Nation Branding and Place Marketing
NGOs – The Self-appointed Altruists
The Wages of Science
The Lessons of Transition
The Morality of Child Labor
Law and Technology
Economics - Psychology's Neglected Branch
By: Dr. Sam Vaknin
Also published by United Press International (UPI)
It is impossible to describe any human action if one does not refer to the meaning the actor sees in the stimulus as well as in the end his response is aiming at.
Ludwig von Mises
Economics - to the great dismay of economists - is merely a branch of psychology. It deals with individual behaviour and with mass behaviour. Many of its practitioners sought to disguise its nature as a social science by applying complex mathematics where common sense and direct experimentation would have yielded far better results.
The outcome has been an embarrassing divorce between economic theory and its subjects.
The economic actor is assumed to be constantly engaged in the rational pursuit of self interest. This is not a realistic model - merely a useful approximation. According to this latter day - rational - version of the dismal science, people refrain from repeating their mistakes systematically. They seek to optimize their preferences. Altruism can be such a preference, as well.
Still, many people are non-rational or only nearly rational in certain situations. And the definition of "self-interest" as the pursuit of the fulfillment of preferences is a tautology.
The theory fails to predict important phenomena such as "strong reciprocity" - the propensity to "irrationally" sacrifice resources to reward forthcoming collaborators and punish free-riders. It even fails to account for simpler forms of apparent selflessness, such as reciprocal altruism (motivated by hopes of reciprocal benevolent treatment in the future).
Even the authoritative and mainstream 1995 "Handbook of Experimental Economics", by John Hagel and Alvin Roth (eds.) admits that people do not behave in accordance with the predictions of basic economic theories, such as the standard theory of utility and the theory of general equilibrium. Irritatingly for economists, people change their preferences mysteriously and irrationally. This is called "preference reversals".
Moreover, people's preferences, as evidenced by their choices and decisions in carefully controlled experiments, are inconsistent. They tend to lose control of their actions or procrastinate because they place greater importance (i.e., greater "weight") on the present and the near future than on the far future. This makes most people both irrational and unpredictable.
Either one cannot design an experiment to rigorously and validly test theorems and conjectures in economics - or something is very flawed with the intellectual pillars and models of this field.
Neo-classical economics has failed on several fronts simultaneously. This multiple failure led to despair and the re-examination of basic precepts and tenets.
Consider this sample of outstanding issues:
Unlike other economic actors and agents, governments are accorded a special status and receive special treatment in economic theory. Government is alternately cast as a saint, seeking to selflessly maximize social welfare - or as the villain, seeking to perpetuate and increase its power ruthlessly, as per public choice theories.
Both views are caricatures of reality. Governments indeed seek to perpetuate their clout and increase it - but they do so mostly in order to redistribute income and rarely for self-enrichment.
Economics also failed until recently to account for the role of innovation in growth and development. The discipline often ignored the specific nature of knowledge industries (where returns increase rather than diminish and network effects prevail). Thus, current economic thinking is woefully inadequate to deal with information monopolies (such as Microsoft), path dependence, and pervasive externalities.
Classic cost/benefit analyses fail to tackle very long term investment horizons (i.e., periods). Their underlying assumption - the opportunity cost of delayed consumption - fails when applied beyond the investor's useful economic life expectancy. People care less about their grandchildren's future than about their own. This is because predictions concerned with the far future are highly uncertain and investors refuse to base current decisions on fuzzy "what ifs".
This is a problem because many current investments, such as the fight against global warming, are likely to yield results only decades hence. There is no effective method of cost/benefit analysis applicable to such time horizons.
How are consumer choices influenced by advertising and by pricing? No one seems to have a clear answer. Advertising is concerned with the dissemination of information. Yet it is also a signal sent to consumers that a certain product is useful and qualitative and that the advertiser's stability, longevity, and profitability are secure. Advertising communicates a long term commitment to a winning product by a firm with deep pockets. This is why patrons react to the level of visual exposure to advertising - regardless of its content.
Humans may be too multi-dimensional and hyper-complex to be usefully captured by econometric models. These either lack predictive powers or lapse into logical fallacies, such as the "omitted variable bias" or "reverse causality". The former is concerned with important variables unaccounted for - the latter with reciprocal causation, when every cause is also caused by its own effect.
These are symptoms of an all-pervasive malaise. Economists are simply not sure what precisely constitutes their subject matter. Is economics about the construction and testing of models in accordance with certain basic assumptions? Or should it revolve around the mining of data for emerging patterns, rules, and "laws"?
On the one hand, patterns based on limited - or, worse, non-recurrent - sets of data form a questionable foundation for any kind of "science". On the other hand, models based on assumptions are also in doubt because they are bound to be replaced by new models with new, hopefully improved, assumptions.
One way around this apparent quagmire is to put human cognition (i.e., psychology) at the heart of economics. Assuming that being human is an immutable and knowable constant - it should be amenable to scientific treatment. "Prospect theory", "bounded rationality theories", and the study of "hindsight bias" as well as other cognitive deficiencies are the outcomes of this approach.
To qualify as science, economic theory must satisfy the following cumulative conditions:
a. All-inclusiveness (anamnetic) – It must encompass, integrate, and incorporate all the facts known about economic behaviour.
b. Coherence – It must be chronological, structured and causal. It must explain, for instance, why a certain economic policy leads to specific economic outcomes - and why.
c. Consistency – It must be self-consistent. Its sub-"units" cannot contradict one another or go against the grain of the main "theory". It must also be consistent with the observed phenomena, both those related to economics and those pertaining to non-economic human behaviour. It must adequately cope with irrationality and cognitive deficits.
d. Logical compatibility – It must not violate the laws of its internal logic and the rules of logic "out there", in the real world.
e. Insightfulness – It must cast the familiar in a new light, mine patterns and rules from big bodies of data ("data mining"). Its insights must be the inevitable conclusion of the logic, the language, and the evolution of the theory.
f. Aesthetic – Economic theory must be both plausible and "right", beautiful (aesthetic), not cumbersome, not awkward, not discontinuous, smooth, and so on.
g. Parsimony – The theory must employ a minimum number of assumptions and entities to explain the maximum number of observed economic behaviours.
h. Explanatory Powers – It must explain the behaviour of economic actors, their decisions, and why economic events develop the way they do.
i. Predictive (prognostic) Powers – Economic theory must be able to predict future economic events and trends as well as the future behaviour of economic actors.
j. Prescriptive Powers – The theory must yield policy prescriptions, much like physics yields technology. Economists must develop "economic technology" - a set of tools, blueprints, rules of thumb, and mechanisms with the power to change the " economic world".
k. Imposing – It must be regarded by society as the preferable and guiding organizing principle in the economic sphere of human behaviour.
l. Elasticity – Economic theory must possess the intrinsic abilities to self organize, reorganize, give room to emerging order, accommodate new data comfortably, and avoid rigid reactions to attacks from within and from without.
Many current economic theories do not meet these cumulative criteria and are, thus, merely glorified narratives.
But meeting the above conditions is not enough. Scientific theories must also pass the crucial hurdles of testability, verifiability, refutability, falsifiability, and repeatability. Yet, many economists go as far as to argue that no experiments can be designed to test the statements of economic theories.
It is difficult - perhaps impossible - to test hypotheses in economics for four reasons.
a. Ethical – Experiments would have to involve human subjects, ignorant of the reasons for the experiments and their aims. Sometimes even the very existence of an experiment will have to remain a secret (as with double blind experiments). Some experiments may involve unpleasant experiences. This is ethically unacceptable.
b. Design Problems - The design of experiments in economics is awkward and difficult. Mistakes are often inevitable, however careful and meticulous the designer of the experiment is.
c. The Psychological Uncertainty Principle – The current mental state of a human subject can be (theoretically) fully known. But the passage of time and, sometimes, the experiment itself, influence the subject and alter his or her mental state - a problem known in economic literature as "time inconsistencies". The very processes of measurement and observation influence the subject and change it.
d. Uniqueness – Experiments in economics, therefore, tend to be unique. They cannot be repeated even when the SAME subjects are involved, simply because no human subject remains the same for long. Repeating the experiments with other subjects casts in doubt the scientific value of the results.
d. The undergeneration of testable hypotheses – Economic theories do not generate a sufficient number of hypotheses, which can be subjected to scientific testing. This has to do with the fabulous (i.e., storytelling) nature of the discipline.
In a way, economics has an affinity with some private languages. It is a form of art and, as such, it is self-sufficient and self-contained. If certain structural, internal constraints and requirements are met – a statement in economics is deemed to be true even if it does not satisfy external (scientific) requirements. Thus, the standard theory of utility is considered valid in economics despite overwhelming empirical evidence to the contrary - simply because it is aesthetic and mathematically convenient.
So, what are economic "theories" good for?
Economic "theories" and narratives offer an organizing principle, a sense of order, predictability, and justice. They postulate an inexorable drive toward greater welfare and utility (i.e., the idea of progress). They render our chaotic world meaningful and make us feel part of a larger whole. Economics strives to answer the "why’s" and "how’s" of our daily life. It is dialogic and prescriptive (i.e., provides behavioral prescriptions). In certain ways, it is akin to religion.
In its catechism, the believer (let's say, a politician) asks: "Why... (and here follows an economic problem or behaviour)".
The economist answers:
"The situation is like this not because the world is whimsically cruel, irrational, and arbitrary - but because ... (and here follows a causal explanation based on an economic model). If you were to do this or that the situation is bound to improve".
The believer feels reassured by this explanation and by the explicit affirmation that there is hope providing he follows the prescriptions. His belief in the existence of linear order and justice administered by some supreme, transcendental principle is restored.
This sense of "law and order" is further enhanced when the theory yields predictions which come true, either because they are self-fulfilling or because some real "law", or pattern, has emerged. Alas, this happens rarely. As "The Economist" notes gloomily, economists have the most disheartening record of failed predictions - and prescriptions.
The Misconception of Scarcity
By: Dr. Sam Vaknin
Also published by United Press International (UPI)
My love as deep; the more I give to thee,
The more I have, for both are infinite.
(William Shakespeare, Romeo and Juliet, Act 2, Scene 2)
Are we confronted merely with a bear market in stocks - or is it the first phase of a global contraction of the magnitude of the Great Depression? The answer overwhelmingly depends on how we understand scarcity.
It will be only a mild overstatement to say that the science of economics, such as it is, revolves around the Malthusian concept of scarcity. Our infinite wants, the finiteness of our resources and the bad job we too often make of allocating them efficiently and optimally - lead to mismatches between supply and demand. We are forever forced to choose between opportunities, between alternative uses of resources, painfully mindful of their costs.
This is how the perennial textbook "Economics" (seventeenth edition), authored by Nobel prizewinner Paul Samuelson and William Nordhaus, defines the dismal science:
"Economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people".
The classical concept of scarcity - unlimited wants vs. limited resources - is lacking. Anticipating much-feared scarcity encourages hoarding which engenders the very evil it was meant to fend off. Ideas and knowledge - inputs as important as land and water - are not subject to scarcity, as work done by Nobel laureate Robert Solow and, more importantly, by Paul Romer, an economist from the University of California at Berkeley, clearly demonstrates. Additionally, it is useful to distinguish natural from synthetic resources.
The scarcity of most natural resources (a type of "external scarcity") is only theoretical at present. Granted, many resources are unevenly distributed and badly managed. But this is man-made ("internal") scarcity and can be undone by Man. It is truer to assume, for practical purposes, that most natural resources - when not egregiously abused and when freely priced - are infinite rather than scarce. The anthropologist Marshall Sahlins discovered that primitive peoples he has studied had no concept of "scarcity" - only of "satiety". He called them the first "affluent societies".
This is because, fortunately, the number of people on Earth is finite - and manageable - while most resources can either be replenished or substituted. Alarmist claims to the contrary by environmentalists have been convincingly debunked by the likes of Bjorn Lomborg, author of "The Skeptical Environmentalist".
Equally, it is true that manufactured goods, agricultural produce, money, and services are scarce. The number of industrialists, service providers, or farmers is limited - as is their life span. The quantities of raw materials, machinery and plant are constrained. Contrary to classic economic teaching, human wants are limited - only so many people exist at any given time and not all them desire everything all the time. But, even so, the demand for man-made goods and services far exceeds the supply.
Scarcity is the attribute of a "closed" economic universe. But it can be alleviated either by increasing the supply of goods and services (and human beings) - or by improving the efficiency of the allocation of economic resources. Technology and innovation are supposed to achieve the former - rational governance, free trade, and free markets the latter.
The telegraph, the telephone, electricity, the train, the car, the agricultural revolution, information technology and, now, biotechnology have all increased our resources, seemingly ex nihilo. This multiplication of wherewithal falsified all apocalyptic Malthusian scenarios hitherto. Operations research, mathematical modeling, transparent decision making, free trade, and professional management - help better allocate these increased resources to yield optimal results.
Markets are supposed to regulate scarcity by storing information about our wants and needs. Markets harmonize supply and demand. They do so through the price mechanism. Money is, thus, a unit of information and a conveyor or conduit of the price signal - as well as a store of value and a means of exchange.
Markets and scarcity are intimately related. The former would be rendered irrelevant and unnecessary in the absence of the latter. Assets increase in value in line with their scarcity - i.e., in line with either increasing demand or decreasing supply. When scarcity decreases - i.e., when demand drops or supply surges - asset prices collapse. When a resource is thought to be infinitely abundant (e.g., air) - its price is zero.
Armed with these simple and intuitive observations, we can now survey the dismal economic landscape.
The abolition of scarcity was a pillar of the paradigm shift to the "new economy". The marginal costs of producing and distributing intangible goods, such as intellectual property, are negligible. Returns increase - rather than decrease - with each additional copy. An original software retains its quality even if copied numerous times. The very distinction between "original" and "copy" becomes obsolete and meaningless. Knowledge products are "non-rival goods" (i.e., can be used by everyone simultaneously).
Such ease of replication gives rise to network effects and awards first movers with a monopolistic or oligopolistic position. Oligopolies are better placed to invest excess profits in expensive research and development in order to achieve product differentiation. Indeed, such firms justify charging money for their "new economy" products with the huge sunken costs they incur - the initial expenditures and investments in research and development, machine tools, plant, and branding.
To sum, though financial and human resources as well as content may have remained scarce - the quantity of intellectual property goods is potentially infinite because they are essentially cost-free to reproduce. Plummeting production costs also translate to enhanced productivity and wealth formation. It looked like a virtuous cycle.
But the abolition of scarcity implied the abolition of value. Value and scarcity are two sides of the same coin. Prices reflect scarcity. Abundant products are cheap. Infinitely abundant products - however useful - are complimentary. Consider money. Abundant money - an intangible commodity - leads to depreciation against other currencies and inflation at home. This is why central banks intentionally foster money scarcity.
But if intellectual property goods are so abundant and cost-free - why were distributors of intellectual property so valued, not least by investors in the stock exchange? Was it gullibility or ignorance of basic economic rules?
Not so. Even "new economists" admitted to temporary shortages and "bottlenecks" on the way to their utopian paradise of cost-free abundance. Demand always initially exceeds supply. Internet backbone capacity, software programmers, servers are all scarce to start with - in the old economy sense.
This scarcity accounts for the stratospheric erstwhile valuations of dotcoms and telecoms. Stock prices were driven by projected ever-growing demand and not by projected ever-growing supply of asymptotically-free goods and services. "The Economist" describes how WorldCom executives flaunted the cornucopian doubling of Internet traffic every 100 days. Telecoms predicted a tsunami of clients clamoring for G3 wireless Internet services. Electronic publishers gleefully foresaw the replacement of the print book with the much heralded e-book.
The irony is that the new economy self-destructed because most of its assumptions were spot on. The bottlenecks were, indeed, temporary. Technology, indeed, delivered near-cost-free products in endless quantities. Scarcity was, indeed, vanquished.
Per the same cost, the amount of information one can transfer through a single fiber optic swelled 100 times. Computer storage catapulted 80,000 times. Broadband and cable modems let computers communicate at 300 times their speed only 5 years ago. Scarcity turned to glut. Demand failed to catch up with supply. In the absence of clear price signals - the outcomes of scarcity - the match between the two went awry.
One innovation the "new economy" has wrought is "inverse scarcity" - unlimited resources (or products) vs. limited wants. Asset exchanges the world over are now adjusting to this harrowing realization - that cost free goods are worth little in terms of revenues and that people are badly disposed to react to zero marginal costs.
The new economy caused a massive disorientation and dislocation of the market and the price mechanism. Hence the asset bubble. Reverting to an economy of scarcity is our only hope. If we don't do so deliberately - the markets will do it for us, mercilessly.