Thursday, April 24, 2014

Methodological Individualism – A Reformulation

It has not been unpopular from some scholars to attack methodological individualism as an unnecessary constraint on economic analysis. Individual action does not occur in an institutional vacuum. To reduce economics, or any social science, to only individual choice ignores the significance of emergent phenomena that shape the world we live in. Geoff Hodgson makes a passionate call for a reasoned compromise:

Despite the impression given by many adherents of methodological individualism, it is quite legitimate to deny that only purposes or actions of individuals are explanatory… These beliefs [about individual autonomy] are not undermined by a conviction that whilst people are, on the one hand, purposeful and have real choices, they are, on the other, moulded by their cultural and institutional environment. (Hodgson 1986, 222)

Hodgson claims that Austrian economists overlook this feature in their research. Just as macroeconomics can benefit from microfoundations, macro – or emergent – foundations are always implicit in microeconomic analysis.

Though his claim has legitimacy, Hodgson’s critique of his opponents is more sweeping than merited. In the same work, Hodgson lumps together the views of Hayek and Mises concerning methodological individualism and social wholes. Hayek’s formulation of social exchange and development clearly includes collectives as actual entities, even if he is not always consistent. These entities exist in the form of rules that guide action, which when adopted, create norms not dependent on any single person. “Society can thus exist only if by a process of selection rules have evolved which lead individuals to behave in a manner which makes social life possible (Hayek, 1973, 44 quoted in Andreozzi 2005).” This insight from Hayek presents those who seek to reformulate the nature of the individual in society a preliminary goal post from which to begin analysis. Society can be analyzed, in part, by the rules that it embodies. But first I shall review the conception of methodological individualism often promoted by Austrian economists.

In the textbook version of Austrian economics, only individual action matters. This leads to a tendency to disregard the formative nature of institutions. Institutions serve individuals, not the other way around. As Ludwig von Mises described in his canonical work Human Action,

…Methodological individualism, far from contesting the significance of such collective wholes, considers it as one of its main tasks to describe and to analyze their becoming and their disappearing, their changing structures, and their operation. And it chooses the only method fitted to solve this problem satisfactorily.

First we must realize that all actions are performed by individuals. A collective operates always through the intermediary of one or several individuals whose actions are related to the collective as the secondary source… The hangman, not the state, executes a criminal. (1996, 43)

But the hangman receives authority from the “state”. The state is an entity that is bigger than any one person. While any action requires an individual, the state practically subsumes them when they act as its agent. Individual action is constrained by the state apparatus. Individuals might move in and out of the state, but the state remains. This may have been part of the decisions of particular individuals, but those individuals are logically replaceable by others. Methodological individualism in the strict sense that Mises presents it breaks down. But this need not be so if we accept an interaction between institutions and individuals, which in some instances Mises comes close to acknowledging.

Mises’s argument is likely skewed due to his context which appears to have promoted confusion between political individualism and methodological individualism in his writing. During his career, he battled collectivist perceptions that had been common in Germany like the idea of a fatherland, the volk, and so on. These colloquial references to the collective lack much substance beyond culture. But many collectives are well formed. This does not prevent Mises from denouncing analysis of collectives more generally,

It is illusory to believe that it is possible to visualize collective wholes. They are never visible; their cognition is always the outcome of the understanding of the meaning which acting men attribute to their acts. We can see a crowd, i.e., a multitude of people. Whether this crowd is a mere gathering or a mass (in the sense in which this term is used in contemporary psychology) or an organized body or any other kind of social entity is a question which can only be answered by understanding the meaning which they themselves attach to their presence. And this meaning is always the meaning of individuals. Not our senses, but understanding, a mental process, makes us recognize social entities. (43)

In terms of imaginary collectives that lack substantial structure, Mises is more correct than not. Collectives like government, corporations, and religious groups, however, do not fall under the same category as a crowd. We might better understand these institutions as rules and structure that are epiphenomena of particular networks. As rules become formalized through building of indigenously introduced exogenous institutions, they are embodied in a real, existent entity that govern interactions within particular networks (Boettke, Coyne, and Leeson 2008). Analysis then includes not only the individual, but also the system. Interactions occur within network and between networks, with different networks embodying different norms and rule sets. These rules more tightly constrain the actions of agents within the system than do informal norms, thus we can observe the interaction between the individual agent and emergent phenomena concretized by the creation of formal institutions.

This process has been recognized within development literature, but it has not been explicictly stated in regard to methodological individualism. In their presentation of the process of social development, North, Wallace, and Weingast present three doorstep conditions for moving into what they call an open-access order where political violence is constrained and political power is systematized and contestable (2009). Their second doorstep condition for entering an open-access order is the creation of perpetually lived institutions in both the public and private spheres of life:

The capacity to form and support perpetually lived organizations has direct consequences for a society’s ability to structure social relationships over time. The creation of legal personalities for organizations constitutes an essential element of perpetual life; it is inherently impersonal because it is defined without reference to any specific individuals. (2009, 158)

The growth of well-developed institutions both constrain and expand the option sets of individuals. They perform a coordinating function amongst individuals by providing boundaries for individual action. When the state takes action, it is not so important who serves as its agent, only that someone does. Something bigger than the individual molds the actions of every individual within their network.

These coordinating functions also interact with one another. When institutions collide, some amount of conflict results. To be clear, action always occurs at the individual level. When robust institutions are included and, in this case, when they conflict, the nature of the action changes. One might say that two nation’s militaries battled one another. In reality, many individuals with weapons attacked one another, but in doing so, they acted as agents of the state. Their constraints change the moment they put on uniforms and are depending on the role they adopt or are assigned. This sort of analysis makes little sense without recognizing the existence and importance of emergent institutions like the state and the constraints placed upon its agents.

The world is dynamic. Social economy must be modeled as such. Methodological individualism need not be discarded. It must be integrated into a deeper form of analysis. Its general spirit is correct. Action occurs at the individual level. The individual, however, is constantly engaged in a conversation with society about what his or her actions should and can be. Society, in this sense, is defined not simply as everyone else, but also as the formal and informal institutions that constantly influence one’s actions. Mises and Hayek may not have been amenable to studying why people act as they do, as this is not a question of prime interest to economists. Economists should ask how and why one’s options are shaped and constrained by emergent institutions. The search for an answer to this will enable us to form a more robust method of analysis.

Andreozzi, Luciano. “Hayek Reads the Literature on the Emergence of Norms.” Econ Stor Working Paper no. 0503. 2005.

Boettke, Peter, Coyne, and Leeson. “Institutional Stickiness and the New Development Economics.” The American Journal of Economics and Sociology 64, no. 2 (April 2008): 331-358.

Hodgson, Geoff. “Behind Methodological Individualism.” Cambridge Journal of Economic 10 (1986): 211-224.

Mises, Ludwig von. Human Action: A Treatise on Economics Irvington-on-the-Hudson, NY: Foundation for Economic Education, 1996 [1949].

North, Douglass, Wallace, and Weingast. Violence and Social Orders New York: Cambridge University Press, 2009.

Friday, April 18, 2014

Thoughts on Lachmann, Determinism, and Free Will

In "The Role of Expectations in Economics as a Social Science", Ludwig Lachmann remarks about determinism,
Does Professor Hicks seriously maintain that the same individual confronted with the same kind of change will invariably react in an identical-and incidentally, predictable-manner? Only such invariability of reaction would entitle us to use intensity of reaction as a criterion of classification. (74)
Lachmann is conflating uncertainty with a lack of determinism. If the future is uncertain that does not mean that the events contained therein cannot be predeterimined given an identical starting state at time t. Some readers might remember that I have before made reference to historical time, making a similar claim as Lachmann here. Upon further reflection, I believe that I might have been making the same error.

If the future is uncertain from the point of view of human consciousness, but predetermined, it implies that free will as we conceive it is an illusion. I'm still not sure what to make of this conclusion, maybe more on that in the future.

Tuesday, April 8, 2014

Rule-Based Macroeconomics: A Possible Avenue for Non-Equilibrium Theorizing

If you have been reading my blog recently, you know that I have not written kindly about the integration of rational expectations and the efficient markets hypothesis into Austrian economics. This might seem strange to any readers who believe that markets work. I sympathize with that perspective, but I believe it is inappropriate to assume this. As I have noted about some modern Austrian macroeconomic models, reliance on RE and EMH assumes disequilibrium out of existence unless it is caused by an exogenous shock. RE and EMH may approximate market outcomes 99% of the time, or even 99.9% of the time, but the remainder, (1 – p), needs to be understood, especially if its source is endogenous.  Imagine if I have a 1/100 or 1/1000 chance of being struck by lightning every time I step outside. The variance of outcome in the case I am struck is high. According to a quick Google search, there is a 10% chance that I die, and some spectrum of other outcomes. I am not interested in the median result – say, I spend one week in the hospital – if 1 in 10 times I end up dead. Furthermore, in a world of fat tailed probability distributions, which seem to better describe the world of finance than Gaussian distributions, I may not want to optimize expected value if I am not sure how fat the tails are. In other words, I may know that my map of possible outcomes does not cover the entirety of possible outcomes, but I am unsure to what extent it is lacking. This is what George Shackle and Israel Kirzner refer to as surprise: outcomes that one is absolutely ignorant of. If it so happens that the possible outcomes I am missing from my probability distribution have much higher expected losses than any outcome within my probability distribution, I may want to consider not optimizing in a way suggested by RE. 

None of this is to say that RE and EMH are not useful. They provide a teleological compass for fruitful economic analysis. In many cases, however, median outcomes do not matter. In these cases, RE and EMH are better described as an Achilles heel of economic analysis.

What is needed is an economic framework that allows for emergent processes, a non-equilibrium framework. We do not know what the economy will look like in ten years – even absent exogenous shocks – neither should agents in our models. (If you disagree, extend the time frame to 100 years.) 

What is needed is not that Austrian economics “catch-up” to the modern equilibrium paradigm, “but an effort to create the contemporary analytics that might have been created had Austrian macro theorizing continued to evolve since 1940 with the same robustness that it exhibited before 1940 (Wagner, 98).” 

What is needed is a macroeconomics that foregoes determinism associated with RE and EMH and concentrates on rules that guide decision-making and human action. Individuals do not approach “truth” directly. They integrate information according to heuristics, and then act to achieve their ends according to their interpretation of information. 

Those who endeavor to develop this research program must model in terms of heterogeneous agents whose actions are determined according to rule sets. The outcomes of interactions between agents acting according to rule sets and the transformation of rule sets over time may shed light on market processes in a way that equilibrium theorizing cannot.

Monday, April 7, 2014

Latest Revision of "Good as Gold?"

I have posted my latest revision of "Good as Gold?" This was a dramatic overhaul as I combined this paper with another that concerns the monometallism and price instability. An excerpt from the conclusion:

The danger of deflation was augmented by the centralization of gold reserves in the previous half century. In 1914, most of the world’s monetary gold was stored at a small number of central banks. By 1922, “the world market in gold was practically coterminous with the monetary demand of one great country” as nearly half of the world’s monetary gold resided at the Federal Reserve (Hawtrey 1947, 97). Consolidation made prices even more sensitive to changes in the demand and supply of gold. When coordination of independent central banks from the Bank of England ceased, the price of gold became unhinged, swinging wildly between 1914 and 1920 and again between 1929 and 1932. 
This problem was inherent in the system. It was not a defect of the gold standard per se. It was a defect of management under a system of fixed exchange rates. Deflation must follow an unbacked expansion of the money stock by the central bank if larger players like the Bank of England and the Federal Reserve refuse to keep reserve ratios suppressed. Under a system of floating exchange rates, on the other hand, the economy probably would have adjusted to a higher price level and “the subsequent collapse would almost surely not have occurred (Friedman 1961, 68).” Of course, depression also could have been avoided by a return to the gold standard at devalued parities, but such an option was politically unpalatable. In light of political constraints, the economic instability associated with the latter decades of the gold standard was not a glitch, but rather the logical end of an international, monometallic legal tender regime.

Friday, April 4, 2014

The Comparative Advantage of Austrian Economics: Away from Positivism and Into Historical Time

Since the Great Depression, Austrian economics has moved more in the direction of equilibrium theorizing than it had been previously (I have discussed these issues before, so I will spare you). Austrian economists have, to a far lesser extent, embraced germs of uncertainty inherent in Austrian methodology. Some exception include Ludwig Lachmann, Mario Rizzo,and Gerald O'Driscoll. And of course, Hayek, with "The Use of Knowledge in Society" and numerous other works brings to light the complexity of markets and society in general. Despite this, what is lacking is a systematic way to speak about complexity and uncertainty within economics.

Economics has been locked squarely in the positivist paradigm for over a half-century. Adherence to logical time - that is, a paradigm where the end-state of the economy is determined by its starting point and the parameters and assumptions of the model - under assumptions of efficiency robs Austrian economics precisely of what distinguishes the discipline from competing schools of thought: strict adherence to methodological individualism. The integration of Austrian macroeconomics within modern perspective steeped in assumptions of long-run efficiency has resulted in an approach that ignores market process. As modern macroeconomics is engrossed in positivist methodology, it need not concern itself with microfoundations for modeling. The purpose of these models is prediction, not understanding of process (Friedman 1954).[1] Theories are tested by evaluation of their predictive power using econometric models. It should be no surprise, then, that when positivist theories adopt microfoundations, those microfoundations are not substantive and exist only to fulfill a shallow requirement.[2] The functionality of the models remain largely undisturbed. As long as time is logical, outcomes are predetermined by assumptions and parameters. Making a model more complex by adding new parameters does not alter the assumption that for every input, there is a single output.

Peter Boettke and Kyle O’Donnell state the problem without apology. “Pure economic theory, especially equilibrium analysis, is incapable of shedding light on the process by which the subjective knowledge held by individuals is sufficiently adjusted so as to bring about intertemporal plan coordination (2013, 309).” An economics that considers market process must take into account the nature of decision making within a context of imperfect information. Some actors have access to newer, more accurate information than others. Some are better at interpreting the information to make predictions about the future. Others simply copy the actions of those whom they consider smarter than themselves. Under such conditions, a single input might be capable of multiple outputs. To simplify the problem by assuming rational expectations narrows the decision-making set to whatever set of probabilities a model defines as rational. This assumes away the problem of gathering and interpreting information. The approach is both limiting and unnecessary absent a positivist standard (Rector 1991, 219).

To amend the problem requires nothing less than a paradigm shift. As Ralph Rector notes:
From a positivist perspective, interpretive-type data appear irrelevant because they cannot be formalized as testable for quantitative predictions. In contrast to this view, interpretive economists believe that our understanding of important social phenomena has been hindered by the positivist standard of relevancy. (1991, 220)
The new economic framework should not concern itself with scarcity of resources and their single, optimal allocation which has been the emphasis of positivist economics. Agents act in historical time where their actions and the effects of those actions are irreversible. It emphasizes scarcity of knowledge. It must ask, “what are the principles of choice that allow the continual growth of knowledge (Potts 2000, 114)?” This author might add also, “what are the principles that allow the continual growth in the employment of knowledge toward desired ends by a multitude of agents?”

To confront this question, we must consider what constraints limit gathering, interpretation, and creation of new information. While some individuals might be privy to high level interpretation of statistics, most individuals do not have access to such knowledge and most data in the real world does not lend itself to such interpretations. Even if all actors did have access to these methods and all data corresponded to them, it is impossible ex ante for them to know to what degree the model of choice applies to the data in question. A more reasonable scenario is one where individuals rely on heuristics to make economic decisions. From this view, rationality and efficiency lack a clear standard outside duplicability of the action in question. No other standard need be posited and none need act as a teleological compass to guide the construction and results of a model. Such a paradigm does not seek to predict. It seeks to understand and model complexity within the economy and society.

[1] “The ultimate goal of a positive science is the development of a ‘theory’ or, ‘hypothesis’ that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed.”
[2] Acknowledging the reach of the positivistic paradigm also clarifies the tension existent in Muth (1961) as he claims that his theory does not “state that predictions of entrepreneurs are perfect or that their expectations are all the same (317).”