Isn’t modern economic logic circular by design?

Economic analysis relies on models.  It has no choice but to rely on models for the same reason that useful maps ignore a lot of information that is valuable to someone — there’s just too much data in the real world to analyze in one sitting.

Models start with assumptions and then investigate whether the implications of those assumptions contradict the facts.  It is generally acknowledged that the value of a model is open to question when the facts contradict the implications of the model.  (However, it is also common to see a spirited defense of models that are not consistent with the facts.)  When the model is consistent with the facts, the modeller has a winner.  The modeller does not, however, have the winner.  The modeller has just presented us with one of many stories that can explain the facts.

Economics faces the same problems as the field of epidemiology (amongst others):  the model underlying the data analysis assumes causality and statistical methods can be used to show that the assumption of causality is not contradicted by the data.  In fields where controlled studies are impossible there is, however, little hope that statistics can be used to positively confirm that the assumption of causality is a good one.

Thus, economists are frequently found making arguments along the lines of:  Given my assumptions I reach these conclusions.  Since these conclusions are consistent with what we know about the world, my assumptions are good.

To which the logical response is:  Maybe you’re right and maybe you’re wrong; maybe your assumptions are good and maybe they’re bad.  You still haven’t justified to people who have doubts about your model that there is any reason to believe in it.

In short, until economists recognize that they need to defend the assumptions underlying their models at the level of pure theory, they will continue to be accused of circular logic.  In my view the problem with economics today is that only a small subset of economists see the need to defend the value of their arguments on a theoretical level.

Despite my view that most modern economists have yet to come to terms with the basic principles of logic, I actually think that Ted Gayer‘s defense of “market based mechanisms” is correct.  The reason that I think Gayer is correct is because I find Hayek‘s explanation of why market based mechanisms are better convincing — that is, because somebody took the time to convince me at the level of verbal argument and pure theory that market prices are directional signals that are essential to the ability of a successful economy to function.

Too many economists seem to take the view that:  Well, Hayek convinced me, so I feel free to take it as a given that Hayek is correct and expect my readers to do the same.  They should not be surprised if a huge number of people who have never read Hayek find this approach arrogant and illogical.  Any economist who is above using verbal argument to demonstrate why the pure theory underlying his or her approach is correct — even if this just means that the economist paraphrases Hayek —  deserves to be accused of circular logic.

Golden Fetters, Legal Fetters

The interconnectedness of the international financial system is built on limitations.  In the 1920s these were the limitations set by the gold standard.  Nowadays these are the limitations created by the legal status of derivatives.  It is these limitations, which are perceived to protect the value of cross-border contracts, that make it possible for closely intertwined financial markets to develop.

Interconnectedness:  Golden Fetters

In the 1920s and early 30s cross border transactions depended on the operation of the gold standard.  Many cross-border contracts were denominated in sterling, though the dollar was growing in importance.  After the Dawes plan and the stabilization of the German currency, the flow of private sector funds from the US to Germany – denominated in marks – grew dramatically.  Thus, one of the reasons the gold standard was viewed as essential to the stability of the international financial system, was that the decision to go off gold by Britain, the US or Germany was sure to generate an international insolvency crisis.

Because of the structure of international trade, for the key countries whose currencies were used in foreign trade contracts the act of going off gold functioned as a means of transferring equity from the balance sheets of foreign banks and firms to the balance sheets of domestic banks and firms.  In short, one thing was certain:  the day Britain (or the US or Germany after Dawes) went off gold, that action would trigger an international insolvency crisis.

Needless to say, nobody could tell what would be the consequences of an international insolvency crisis and everybody who understood the consequences of leaving the gold standard was fearful that not only would formerly prosperous economies suffer immensely, but that the political consequences could also be disastrous.  This fear of a coming apocalypse drove central bankers – for the most part with the support of their governments – to do everything they could to avoid going off gold and triggering the subsequent insolvency crisis.

The problem with the effort to defend the gold standard was that in order to be successful the defense required universal cooperation.  And in the post World War I environment, there were many contentious issues that precluded genuine cooperation:  not only were differences over war debts and reparations almost impossible to resolve, but countries such as France were very jealous of the key role sterling had played in the world economy over the previous decades and sought to bolster their own position in the world of international finance – even as Britain was determined not to give up its leading role.  Thus, the measure of cooperation that was necessary to preserve the gold standard was unachievable in practice.

For this reason, the attempt to preserve the gold standard was an optimist’s boondoggle.  In retrospect, we know that going off gold was inevitable.

If the central bankers of the mid-twenties had known that their efforts at developing a cooperative solution to the problems they faced were doomed to failure, they might not have postponed the insolvency crisis, but instead let it break earlier.  Just imagine how different European history might be, had Britain chosen in 1925 – after the Dawes plan had opened a window for European recovery – to devalue before returning to gold.  If the financial world had not been struggling through the latter half of the 20s to carry on despite seriously undervalued and overvalued currencies – while at the same time building up cross-border obligations which would collapse in value in the 30s, it is possible that (i) the solvency crisis would have been smaller and (ii) Europe would have found its way to reasonably stable growth.

Interconnectedness:  Legal Fetters

Today we still have the problem of interconnectedness, but instead of being tied by a gold standard, in our flexible exchange rate world the ties are created by a complex web of derivative contracts – designed to protect against movements in exchange rates (amongst other things) just as the gold standard was.

Now we face a similar problem to that of abandoning the gold standard:  The bankruptcy of a major derivatives dealer will result in an international solvency crisis – thus it must be prevented at all costs – just as going off gold had to be prevented.  The question we face is the question that Europe faced in the mid-20s.  Do we protect the solvency of the international financial system via bailouts and economic hardship – or do we let the crisis that is upon us break?

We know now that for the 20s, the crisis was going to break in the end, and can speculate that it might have been smaller if it had broken earlier.  Unfortunately we cannot know whether today’s bailouts will succeed, or just like the 1929 government financed takeover of the Bodencredit Anstalt (Austria’s second largest bank) by the Credit Anstalt Bank – simply lead to a larger collapse a few years down the line.  By 1931 the Austrian bailout had failed.  The losses overwhelmed the Credit Anstalt bank – which was too big to save.

In the 20s, bailouts delayed the crisis, they didn’t prevent it.  Today we are faced with the question:  Can a bailout of the major derivatives dealers succeed?  Or will we find – as the best minds of the 1920s found – that the insolvency crisis will break, if not today, than a few years from today.

The worst mistake would be to treat the current financial structure as legal fetters and listen too closely to claims that any change in legal regime will trigger a crisis of confidence.  People who make these claims sound just like defenders of the gold standard in the 1920s.  History proved them wrong.  The current consensus of historians is that “Breaking with the dead hand of the gold standard was the key to economic revival.”  (Ahamed’s Lords of Finance p. 477)

While the collapse of derivatives markets would – for obvious reasons – create its own insolvency problems, the experience with the gold standard was that it is better to recognize early that the market is breaking down – and to be prepared to rewrite contracts so that they can be honored and so that systems of international trade become operational again (without government support).  Trying to prop up an old system without making the changes necessary to put it on firm foundations is a fool’s game.

On Lords of Finance 2

Having finished Lords of Finance over the holidays, I conclude that it is an excellent introduction to the role of reparations and war debts in the problems of the 1920s and 30s.  While I have always been told that reparations played a crucial role in the unravelling of Europe’s economies and polities, because these are problems of macroeconomic payment flows, the level of abstraction at which they are usually discussed has always left me in a state of incomprehension muddled with disbelief.

That Ahamed manages to present the problems of reparations in a down to earth manner that simply makes sense is an achievement in itself.

In short, despite its faults I would recommend Lords of Finance to students of the Depression because it presents the big picture of the interrelated macroeconomies with the full gamut of complex payments issues in a very accessible manner and thus can be used as a framework in which to place the pieces of a more careful study of the period.

In one sentence:  First read Lords of Finance; then you’ll be ready to absorb the overwhelming detail of Eichengreen’s Golden Fetters.