Some Puzzles About Brian Arthur’s Views on Complexity

I just finished reading this important paper by Brian Arthur (‘Complexity-economics: A Different Framework for Economic Thought’). I noted my irritation earlier on Facebook that he has no reference to Hayek or any of the Austrians, and wondered how one could write about complexity in economics without mentioning, indeed examining, Hayek’s work. Now that I have read the paper I have a better appreciation of it and think that it is quite well done and is a valuable contribution. Of particular note is the penultimate section, ‘Discussion’ which contains Arthur’s analysis of the place of complexity-economics within economics generally. He provides both methodological and historical perspective. Here is my quick paraphrase of part of that section, focusing on what I find noteworthy.

According to Arthur, complexity-economics is about open-ended systems that are in the continual process of forming and in which the arrival of novelty is on-going. This means that the methods of traditional quantitative economics, concerned mainly with allocation of ends to means in a closed system, and amenable to mathemization, are inapplicable. Other methods have to be found. In particular, time in complexity-economics is real-time as we experience it and not linear, reversible time as expressed in traditional economics. Complexity must deal for example with events that are essentially non-repeatable.

So, while the familiar Marginalist economics (what Austrians call the “pure logic of choice”) has a role to play in economic education it is only one aspect of a much bigger picture, one only now beginning to fully emerge.  In an important way, complexity-economics is close to old-fashioned political economy. There is a synergy between them. “Complexity-economics allows us to explore the world of formation theoretically and systematically; political economy allows us to explore it intuitively and empirically” (17).

So far so good. Quite encouraging. And he does include a passing shout-out to Hayek as a political economist, though no reference. Austrians will see much to agree with albeit they will wonder if Arthur came to all this (the ‘literary’ side of things) never having read Hayek, or Lavoie, etc. He speaks of “nonequilibrium” not “disequilibrium”. Never mind. But then he turns to “policy implications”. And as satisfying and reassuring as the discussion so far has been it now becomes incredibly irritating and bewildering. To wit:

“Certainly, complexity teaches us that markets left to themselves possess a tendency to bubbles and crashes, induce a multiplicity of local attractor states, propagate events through financial networks, and generate a sequence of technological solutions and challenges, and this opens a role for policies of regulating excess, nudging towards favored outcomes, and judiciously fostering conditions for innovation. Colander and Kupers (2012) express this succinctly as getting meta conditions right. (18, italics added)”

So the principle lesson he draws from his perceptive, and expert, understanding of complexity is that “markets left to themselves” exhibit bubbles and crashes that open the way for benevolent regulation? How can this be right? No mention of the amazing self-regulating properties of the market. Where is the ‘invisible hand’? No mention of “complex adaptive systems” or converging network effects, never mind “spontaneous order”. Now maybe I am being picky, but in a contemplative piece on the place and significance of complexity-economics surely the first and foremost of characteristics to note are the convergent and homeostatic properties of many complex social systems. Am I wrong in thinking that this is a big part of the complexity literature? But they are nowhere to be found in this paper.

It gets worse. He goes on to blame an inability to see the benefits of and necessity for regulation on equilibrium economics. (And here we all thought that the neoclassical perfect general equilibrium edifice lent itself to the advocacy of central planning a la Oskar Lange. Does Arthur even know about that?)

“I believe we can make a stronger statement. The failures of economics in the practical world are largely due to seeing the economy in equilibrium. If we look at the economic crises of the last 25 years—the debacle that followed the freeing of markets in Russia in 1990, the extensive gaming of California’s energy market after the lifting of regulations in 2000, the collapse of Iceland’s banks in 2008, the ongoing Euro crisis, the Wall Street meltdown of 2008—all these were caused in no small part by the exploitation of the system by a few well-positioned players, or by markets that careened out of control (Arthur, 2010a). Equilibrium thinking cannot “see” such exploitation in advance for a subtle reason: by definition, equilibrium is a condition where no agent has any incentive to diverge from its present behavior, therefore exploitive behavior cannot happen. And it cannot see extreme market behavior easily either: divergences are quickly corrected by countervailing forces. By its base assumptions, equilibrium economics is not primed to look for exploitation of parts of the economy or for system breakdowns.

Complexity-economics, by contrast, teaches us that the economy is permanently open to response and that every part of it is open to new behavior—to being exploited for gain, or to abrupt changes in structure. A complexity outlook would recommend putting carefully thought out controls in place, much as authorities put sensible building codes in place in seismic regions.” (18, italics added).

And herein lies the explanation for his neglect of Hayek and similar approaches. It does not fit into his topsy-turvy mindset, his view of the social universe in which complexity applies to everything in that universe except government regulation and policy-making. He refers to “the exploitation of the system by a few well-positioned players” in the market, but seems oblivious to the much greater danger of such well-placed players in government. Knowledge and incentive problems don’t seem to exist for him. He is in the grip of the Keynesian presumption that all that is necessary is to put the right people (the complexity economists) in charge of designing the system of regulation.

Many, I am sure many complexity-economists included, will see this as precisely the wrong lesson to learn. The correct lesson, surely, is that policy in a complex world should be humbled by the inescapable unpredictabilities implied by ongoing formative social processes in real time embodying novelty; should incline toward the setting of general abstract rules at the constitutional level, less amenable to exploitation than ad hoc regulation, as so clearly explained by Hayek, Buchanan and others (Lewin, 2014).

For me this was a revealing lesson in power of mindset. Forgive my naiveté.

References.

Arthur, W.B., 2010a. “Exploitive Behavior in Policy Systems,” Mss., IBM Almaden.

Arthur, W.B., 2013. Complexity-economics: A Different Framework for Economic Thought’ SFI Working paper: 2013-04-012, Sante Fe Institute. 

Colander, D, and R. Kupers. 2012. Laissez-Faire Activism: The Complexity Frame for Policy, Princeton.

Lewin, 2014. “Policy Design and Execution in a Complex World: Can We Learn from the Financial Crisis?” working paper,

http://www.utdallas.edu/~plewin/Policy%20Design%20and%20Execution%20in%20a%20Complex%20World.pdf

Pondering Piketty – A Simple Analytical Framework

Introduction

When Thomas Piketty’s book (Piketty, 2014) burst upon the international scene less than a year ago, I felt pressure to write a comprehensive review of this aggressive attack on free-market economics. After all, it was based, as its title implies, on an exposition of the essential nature of “capital” – as in “Capitalism” – and had I not spent a lifetime in the grip of capital theory?

So I got the book and began to plough through it. It proved much more tedious than the reviews I had already read had prepared me to expect. Piketty lays out his premises and conclusions in the first few chapters. So, I already realized that his approach was full of fallacies, that it was fundamentally flawed. How does one then proceed to go through the remaining part of the 655 pages knowing there is no redemption, in fact that the rest will be either irrelevant padding or a piling-on of further fallacies.

By the time I made it through the book, the reviews, scholarly and more informal, had accumulated. It is a fair bet that, numerous though they are, all of the criticisms that could be made of the book have been made somewhere. Thus the marginal value of any review I could offer is probably now close to zero.[1] However, as I was thinking about it, I realized that many, if not all, aspects of Piketty’s approach can be expressed in a simple framework which might be of use to some. I cannot say that this has not been done  before, in some form or other, only that I have not seen it, and that, in any case, it may be of value.

I will, therefore, say very little about the details of the book – how it is written and organized. I have already elsewhere delivered a sweeping evaluation, to wit: Piketty is wrong on the data, the economics, and the policy, otherwise this is a valuable book. You might think it a bit too scathingly smug. But, what I have read since writing that, has enforced my view. In addition to his dubious use of aggregates (about which I will have something to say) it now appears that a strong case can be made that Piketty has distorted and/or fabricated data (Magness and Murphy, 2014). And his economics is surely abysmal, to the point of evincing basic misunderstandings of the workings of supply and demand (McCloskey, 2014, 91). On the matter of policy, I need no confirmation of my conviction that his recommendation borders on insanity.

There are, however, two general comments I want to make about the book. First, many, though by no means all, of the reviews I have read, including some by highly critical authors, suggest that Piketty’s book is, for all its faults, admirable; that it is the work of a serious author with integrity and the best of intentions - Intelligent, industrious, but mistaken and misguided. Perhaps I lack the capacity for charitable interpretation, but I do not see it in this way. The book strikes me as pretentious and almost completely devoid of merit. Its tone, for all the superficial self-effacing expressions to the contrary notwithstanding, is arrogant, something particularly galling coming from someone who has not taken the time (in the purported twenty years of incubation that this book endured) to properly understand his subject.

Secondly, and more importantly, the book is clearly mistitled. It should be titled “Inequality in the Twenty-First Century”. It is from start to finish a book about the evil of growing inequality. Yet, while the book mounts a mountain of evidence to support the assertion that inequality is growing (a project that ultimately fails, as many have shown) there is no real effort to support the assertion that inequality, in itself, is bad. Some reviews have addressed the ethical question of how this concern with inequality elevates resentment and envy. But I have not seen any discussion of the fact that time and again Piketty tries to bolster his case by asserting, without a shred of evidence, that social inequality results ultimately in “social instability” (for example, 10, 21). Indeed, Piketty recognizes that inequality in itself may not be a bad thing, but becomes bad when it is unjustified and against the “public interest” (33). And, of course, he knows what is in the “public interest.”

A simple framework

Piketty’s framework consists of a few basic categories that can be captured using the following.

Y = rK + wL

This is an accounting identity, where Y is national income, r the rate of earnings of capital, K, and w is the wage rate, the rate of earnings of labor, L.

Piketty divides the set of all productive resources into two (exhaustive) categories capital, K, and labor, L, whose owners earn r and w per unit respectively. Thus the earnings of K and L are rK and wL respectively. And the shares of K and L are rK/Y and wL/Y respectively – which we may write as s_K and s_L respectively.

Piketty’s project is to show that the laws of capitalism imply that s_K/s_L rises without limit, thus destabilizing the society. To do this he posits the fundamental equation that i > y, where i is the rate of interest, also the rate of earnings of K (i = rK/K), and y is the rate of growth of total incomes ([1/t]dY/Y = gY, explained below).[2]

Piketty reasons that if the earnings of K grow more rapidly than earnings in general, this must imply that K’s share is growing, thus increasing inequality. QED.

Let’s consider s_K and s_L in a little more detail.

As a tolerable approximation we can write

g(s_K) = gr + gK – gY

and

g(s_L) = gw + gL – gY

Where g is the instantaneous percentage rate of growth operator (aka, dlog/dt).

If r is constant so that gr = 0 and gK  > gy, s_K will rise.

But if w is constant or positive and gw + gL > gY, s_L will rise.

Clearly, the variables are connected.

g(s_K/s_L) = (gr + gK) – (gw + gL).

If gr = 0, income inequality (s_K/s_L) will rise iff gK > gw + gL, that is, iff capital grows faster than labor plus the increase in wages.

So even with this simple, really simplistic, framework[3], Piketty’s conclusion does not follow unless one discounts the effects of a large increase in the real wage of pure labor. Indeed real wages have risen astronomically over the period of Piketty’s analysis, but presumably he would argue not sufficiently relative to the earnings of capital – a really astounding claim, that suggests further analysis of this framework is necessary.

What Do These Variables Mean? 

The conflation of personal and functional income distribution

By using only two categories, K and L, Piketty stacks the cards. In examining the income earned by K and L he is conflating the personal distribution of income with the functional distribution of income. To say that K earns income is at best a metaphor. It really means the owners of K earn income. And the same is true of L. Labor rents out its services in return for wages. By drawing conclusions about inequality of incomes from this, Piketty seems to think that all capital-owners own only capital (from which they derive their earnings) and, more importantly, all workers own only labor – no capital – exclusively from which they derive their earnings. What happens if workers own capital (for example by way of their pension investments)? Then the earnings of capital relative to the earnings of labor cannot be taken as coterminous of the earnings of capital owners relative to the earnings of workers. He does have a lot to say about who owns capital, but it is confused.

The neglect of human capital

This conflation is particularly egregious, potentially fatal to his argument, for the case of human capital. Piketty explicitly (and cavalierly) excludes  human capital from his consideration. Yet, human capital is arguably the single most important factor in explaining personal earnings. If we include the accumulation of human capital in capital accumulation as a whole, the tendency would clearly be toward a reduction in inequality – even in the narrow sense in which Piketty presents it.

What does capital mean?

Piketty has a sub-section with the same title (45). His answer is patently inadequate.

To use these kinds of aggregates is always to risk incoherence. This is especially true in the case of capital. A nation’s physical productive capital refers to its non-human instruments of production – machinery, raw-materials, minerals, buildings and land (some have a separate category for land). Beer-barrels, blast furnaces, harbor installations and hotel-room furniture are all capital (Lachmann 1956 [1978]). They are “capital-goods.” Clearly this is a category of diverse and heterogeneous items. In fact there are thousands of different sub-categories of physical capital goods and, owing to the persistent improvement of technology, the number is growing even while the composition of sub-categories changes.

Why are capital-goods valuable? They are valuable only because they are able, when grouped in appropriate combinations, and used together with labor services, to produce goods and services that people (consumers) value and are willing to pay for. But the value of any single capital-good is a matter of speculation. What someone will pay for it depends on his forecast of the value of the stream of future revenues that can be earned by employing this capital-good in a productive capital combination.

The value of the total of all capital goods is thus not an observable phenomenon. Yet this is what K is intended to convey. It is meant to be an index of the physical magnitude of the capital of the economy. But since this category of resources is composed of thousands of incommensurate items, the only way such an index can be constructed is by adding them together on the basis of their supposed values and deflating by some suitable price-index. Still, it is not a physical quantity of any observable entity. The value of any single capital-good depends on the flow of prospective revenue it is expected to produce, but, as this revenue is earned over time it must be discounted in order to arrive at the present value of the capital-good. In other words, an interest rate is already implicit in the construction of K; its magnitude depends on the interest rate used to discount the various income streams. Thus for Piketty to argue that the interest rate is the return to capital, is to commit an elementary but significant error (to be discussed further below).

In fact there is no such thing as a total of productive physical capital. There are only individual forecasts of what each capital-project (composed of capital and labor combinations) will earn. Only in the idealized theory of neoclassical economics, where all of these individual forecasts are identical and exactly match what will actually transpire, a world of equilibrium, can one meaningfully talk of such a total. In the real-world it is precisely the differences between these forecasts, between the visions of different and competing entrepreneurs, that drive the market-process in which many production plans fail and some succeed. It is a process of implicit experimentation, a dynamic process and there is nothing automatic about it.

What is the interest rate?

It follows that there is no such thing as a return to capital in general, an r, that is the rate of earnings on K that is equal to interest. Interest is a reflection of time-preference, of the discount applied, under various circumstance (notably different degrees of perceived risk) to future incomes. It is the cost of borrowing, the price of credit. It is the cost of financing productive projects and represents the sacrifice made for not consuming value now in favor of waiting until later. If such a sacrifice is to be made it must be deemed worth it. So, for a productive project to be undertaken it must earn at least the value of financing it, after all other expenses are paid. Interest is not the return to capital. It is the cost of financing. It is a separate cost of production.

What then does capital earn? Capital earns a rental rate. If the capital-goods were rented from a third party rather than owned, their earnings would be the rents paid for them. If they are owned it is as if the owner is renting the capital-good to himself. It is no different with labor. The value of a worker, in terms of capitalized earnings, depends on how much he can sell his services for over time. Since he is the exclusive owner of himself, his capital-value cannot be alienated from himself, the employer must rent him, he must purchase the worker’s services. If we consider labor to be human-capital, then all capital earns a categorically identical rental rate. The interest cost is never equal to the earnings of “capital” except in the sense of “financial capital” which may be used to finance both capital and labor.

Rather than just two (different types of) categories of earnings, there are very many categories all of the same type, namely, they are all potential sources of income. And their earnings depend on the nature of the productive environment in which they are created and deployed and not on any fundamental and immutable laws of capitalism.

What is profit?

In real-world economies successful entrepreneurs earn profits. Very successful entrepreneurs can earn fortunes – that they sometimes bequeath to their heirs. Profits are a disequilibrium phenomenon. There is no positive equilibrium rate of profit. In equilibrium profits are zero. Profits are the return for being right in an uncertain world. They are a residual after all other expenses have been accounted for – including contractual payments to workers (wages), capital-goods owners (rental earnings) and financiers (interest).  If the entrepreneur is also an owner of the capital-goods she uses, and part-financer of the project, these sources of income will, in practice, be inextricably comingled.

Conclusion

In the light of the realities of the dynamic economic processes that increased the standard of living of millions of people by magnitudes of thousands, it is hard to see what relevance Piketty’s i > y could possibly have. In truth, his is a bankrupt vision, based on a set of flat-earth dogmas that should never have been accorded the esteem it now has.

References

Lachmann, L. M. (1956 [1978]). Capital and its Structure. Kansas City: Sheed, Andrews and McMeel. .

Magness, P. W., & Murphy, R. P. (2015, Spring). Challenging the Empirical Contribution of Thomas Piketty's Capital in the 21st Century. Journal of Private Enterprise.

McCloskey, D, N. (2014), Measured, unmeasured, mismeasured, and unjustified pessimism: a review essay of Thomas Piketty’s Capital in the twenty-first century. Erasmus Journal for Philosophy and Economics, 7, 2: 73-115.

Piketty, T. (2014). Capital in the Twenty-First Century. Cambridge: Harvard University Press.

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[1] I created a folder on my desktop called Piketty Pieces. At this moment it contains 77 separate files, being various reviews (critiques) including a 10-part review by The Economist.

[2] Piketty uses r and g to write r > g, but we need a different notation for reasons that will become obvious.

[3] It is a Ricardian-Marxist (classical) framework with land thrown in with capital.

When art is spoiled by propaganda

Just finished watching this four-part mini-series. It provoked a mix of very powerful emotions that, no doubt, will become the spur for an audacious blog on the situation in general, if I have the courage. For right now, let me just note this.

In the decades leading up to the 1967 six-day war the mythology surrounding the establishment of the state of Israel was full of romance and euphemism that buried or glossed over the traumas and injustices done to the Arab population, who we now refer to as Palestinians. Israel was the idol of the left, a phoenix risen from the ashes of Auschwitz - heroic testimony to the resilience of the Jewish people, a symbol of human potential, a confirmation of the validity of optimism. And the Palestinians were mostly ignored. Their plight was seized on as a tool for Pan-Arabism and (increasingly) radical Islam, so that rather than dealing with the problem it was deliberately perpetuated by the power brokers in the Arab world. The UN has been continuously complicit in this insofar as it has continued to recognize all of the descendants of the original refugees as refugees by inheritance. This is unique and totally unprecedented in the many cases of refugee populations with which the UN has had to deal. UNWRA (http://www.unrwa.org/), the agency specially created to deal with the Palestinian refugees continues to this day to encourage a state of dependence and hostility at the expense of the taxpayers of member-countries.

After 1967, with gathering momentum, the pendulum began to swing back as the economic and technological gap between Israel and Palestine widened and Israel became a country with an army of occupation, until today when the picture, the mythology, is exactly at the opposite end of the spectrum. Marx or Hegel would be pleased by this dialectic. The prevailing mythology is one that vilifies the Israelis beyond redemption and glorifies the suffering and resistance of the Palestinians no matter how barbaric it may seem - to leave no doubt that the underlying problem is the illegitimate establishment of Israel itself. We are left to figure out what the obviously implied next action step is.

This mini-series is a fairly sophisticated and very effective instance of this genre of mythology. It contains hard-truths, half-truths and lies, all mixed together, indistinguishable to anyone not very familiar with the real history. It is a clever story about a grandfather (a British soldier in Palestine during the occupation) and his granddaughter (living in England in present day, who goes to Israel to find out about his experiences there). The two stories are told in parallel, flashing back and forward in time. It should be just a very compelling story, but instead it is accompanied by insidious, seductive propaganda that will surely leave the innocent viewer with the conviction that Israel is an evil entity, albeit perhaps grown from a noble but futile dream. So, acts of terrorism are ultimately justified as acts of desperation, comparable to the acts of terrorism perpetrated by the Irgun against the British occupation - a clear case of moral equivalence - except that the Irgun are depicted as unscrupulous thugs, while the Palestinian terrorists remain out of site. We hear almost nothing of Hamas or any of the other terrorist groups and we see only one Hamas fighter very briefly towards the end of about eight hours - who happens to be a radicalized young boy. The depiction of the British occupation makes it seem like the Irgun was *the* Israeli resistance to the occupation, whereas, in truth, it was a very minority group of radicals, who were strongly condemned by the Israeli establishment and army of the time, the Haganah - even to the point that the Haganah outlawed and fought against the Irgun. The Irgun's tactics were never approved by any but a minority of the Israeli population. Can we say the same about the attitude of the Palestinian population about the acts of terror carried out by its radicals? Check the polls.

With regard to the present day, there are some hard-truths, like the brutalization of young Israeli soldiers (just kids, boys and girls) stationed in the midst of large hostile populations, inevitably hardened and morally compromised, and the arrogance and sense of entitlement of some of the radical settlers. It seems that some of the scenes in the series were there simply to make these points rather than to advance the story. But there are also half-truths and omissions - like the depiction of Israeli society as unbelievably affluent and decadent. The Arabs in the movie are always honorable victims and the Israelis are either monsters or hypocrites - even the peace activists.

The truth of the situation is tragic enough. Why the need to concoct these elaborate lies? Why the need to deny Israel of any credit for what it has achieved, and what the Palestinians and Israelis could achieve together in a different world where the power brokers have to defer to the desire for peace by enough people on both sides of the divide? It saddens and frustrates me.

The Promise

The Promise is a gripping, political thriller that examines the origins of the Middle East conflict in events that took place under British rule sixty years ago.