May 16, 2017

Frank Knight, Finn Kydland and a Flat Earth

How refreshing it is to open a book and read that the author's object is
a study in "pure theory". The motive ... is twofold. In the first place, the writer cherishes, in the face of the pragmatic, philistine tendencies of the present age ... the hope that careful, rigorous thinking in the field of social problems does after all have some significance for human weal and woe. In the second place, he has a feeling that the "practicalism" of the time is a passing phase, even to some extent, a pose; that there is a strong undercurrent of discontent with loose and superficial thinking and a real desire, out of sheer intellectual self-respect, to reach a clearer understanding of the meaning of terms and dogmas which pass current as representing ideas.
I am, of course, quoting the preface of Frank Knight's Risk, Uncertainty and Profit. So many times have I had this book on my reading list, only to see it bumped to the side by more pressing literary needs. No more...

Frank Knight belongs in the same category of brilliant thinkers in political economy as Keynes, Hayek, Mises, Shackle, Alchian, Okun, Paul Davidson and Axel Leijonhufvud. These are people who took seriously the social and political relevance of economics. Their thinking runs the whole path, from questions of high theory and complex methodology down to the practical difference that those theoretical and methodological questions will ultimately make. They are no one-trick-ponies, like most modern economists - sadly - have turned out to be. 

It takes time, and a lot of hard work, to build this kind of holistic ability of reasoning. Today's economists are too busy cranking out articles asking about "the effect of X on Y", for which I do not blame them. If you choose a traditional economics career in academia, that is what is expected of you. Nevertheless, one of the consequences of the fragmentation and - to be perfectly honest - trivialization of economics is that it has lost its ability to produce systemic thinkers. 

Or, as we should preferably call them, political economists.  

There is an important, practical side to the question of systemic thought. As an illustration, let me use one of the most famous articles in modern macroeconomics: Time to Build Aggregate Fluctuations by Finn Kydland and Edward Prescott. Published in 1982 in Econometrica, this article investigates the role of sequences in the production of capital goods, and what role those sequences play in the business cycle. The theory they contributed to is better known as Real Business Cycle theory. 

For the research they did, both for this article and subsequently, Kydland and Prescott were awarded the Nobel Memorial Prize in economics in 2004. In other words, some of the world's most influential economists believe that their contributions were at the absolute forefront of the economics discipline. There is nothing wrong with that, per se, but what is striking about Kydland and Prescott is that their path-breaking contribution also illustrates the methodological flaw that runs like an artery right through modern economics. 

This, in turn, illustrates what happens to an academic discipline when it becomes too "practical" in Knight's words, and loses its connection to systemic thought.

In their 1982 article, Kydland and Prescott (1982) assume that the production of capital goods takes several time periods. Those periods are distinctly separated from each other, with a unique part of the construction of capital goods taking place in each period. 

There is nothing wrong with this assumption. The problems begin when they assume that the rest of the economy is operating under traditional Walrasian assumptions of auction pricing, flexible prices and - by logical consequence - perfect foresight (for a brilliant, in-depth examination of this point, see Shackle: Epistemics and Economics). In the Walrasian system, flexible prices set by an auctioneer are to everyone's benefit; we all enjoy our lives the most when prices are acution-determined and ex ante completely flexible.

In practice, this means that you do not know from one day to the next what the prices of milk, bread, beef and tomatoes are going to be. You will find out only when you are at the grocery store and the goods are auctioneered off on a market with many sellers and buyers. 

At the same time, as an employee of a shipyard building oil tankers you get paid under a completely different price regime. It is necessary, namely, for producers of capital goods to secure a set of fixed, contracted prices throughout the production process of each and every capital good they manufacture. If they have no idea what the cost of production is going to be in each of the X time periods it takes to build an oil tanker, they cannot finance the production of their ship. 

Part of securing production costs is to sign a contract, explicitly or (see Arthur Okun: Prices and Quantities) implicitly, with subcontractors, suppliers and workers. The workers will then have a wage they can predict for the next five periods of time.

Yet at the same time as they have a fixed wage, their cost of living is determined on Walrasian auction markets.

The difference in time sequencing, and the consequences thereof for not just pricing but the existence (or absence) of uncertainty, risk and profits (see Alchian: Uncertainty, Evolution and Economic Theory), is a significant problem. It is comparable to a physicist studying gravity by assuming that gravity operates in a universe where Earth is round and revolves around the sun, while the other laws of nature exist in a universe where Earth is flat and the center of the universe.

With this level of methodological creativity, you can claim to prove anything, yet at the end of the day you prove nothing, except that with enough implicit axioms in your pocket, you are impervious to the restrictions that reality imposes on us all. 

This is, in a nutshell, the point that Frank Knight makes in the preface to his book. But his book is also a defining contribution to the discipline of political economy. 

That, however, is a point we will have to return to later. 

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