Capitalistic Musings

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(c) 2002 Copyright Lidija Rangelovska.

Capitalistic Musings

1st EDITION

Sam Vaknin, Ph.D.

Editing and Design:

Lidija Rangelovska

Lidija Rangelovska

A Narcissus Publications Imprint, Skopje 2002

First published by United Press International - UPI

Not for Sale! Non-commercial edition.

(c) 2002 Copyright Lidija Rangelovska.

All rights reserved. This book, or any part thereof, may not be used or
reproduced in any manner without written permission from:

Lidija Rangelovska - write to:

palma@unet.com.mk or to

vaknin@link.com.mk

Visit the Author Archive of Dr. Sam Vaknin in "Central Europe Review":

http://www.ce-review.org/authorarchives/vaknin_archive/vaknin_main.html

Visit Sam Vaknin's United Press International (UPI) Article Archive

ISBN: 9989-929-37-8

http://samvak.tripod.com/guide.html

http://economics.cjb.net

http://samvak.tripod.com/after.html

Created by: LIDIJA RANGELOVSKA

REPUBLIC OF MACEDONIA

C O N T E N T S

I. Economics - Psychology's Neglected Branch

II. The Misconception of Scarcity

III. The Roller Coaster Market - On Volatility

IV. The Friendly Trend

V. The Merits of Inflation

VI. The Benefits of Oligopolies

VII. Moral Hazard and the Survival Value of Risk

VIII. The Business of Risk

IX. Global Differential Pricing

X. The Disruptive Engine - Innovation

XI. Governments and Growth

XII. The Distributive Justice of the Market

XIII. The Myth of the Earnings Yield

XIV. Immortality and Mortality in the Economic Sciences

XV. The Agent-Principal Conundrum

XVI. The Green-Eyed Capitalist

XVII. The Case of the Compressed Image

XVIII. The Fabric of Economic Trust

XIX. Scavenger Economies, Predator Economies

XX. Notes on the Economics of Game Theory

XXI. Knowledge and Power

XXII. Market Impeders and Market Inefficiencies

XXIII. Financial Crises, Global Capital Flows and

the International Financial Architecture

XXIV. O'Neill's Free Dinner - America's Current Account Deficit

XXV. Anarchy as an Organizing Principle

XXVI. Narcissism in the Boardroom

XXVII. The Author

XXVIII. About "After the Rain"

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)

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.

The Roller Coaster Market

On Volatility and Risk

By: Dr. Sam Vaknin

Also published by United Press International (UPI)

Volatility is considered the most accurate measure of risk and, by
extension, of return, its flip side. The higher the volatility, the
higher the risk - and the reward. That volatility increases in the
transition from bull to bear markets seems to support this pet theory.
But how to account for surging volatility in plummeting bourses? At the
depths of the bear phase, volatility and risk increase while returns
evaporate - even taking short-selling into account.

"The Economist" has recently proposed yet another dimension of risk:

"The Chicago Board Options Exchange's VIX index, a measure of traders'
expectations of share price gyrations, in July reached levels not seen
since the 1987 crash, and shot up again (two weeks ago) ... Over the
past five years, volatility spikes have become ever more frequent, from
the Asian crisis in 1997 right up to the World Trade Centre attacks.
Moreover, it is not just price gyrations that have increased, but the
volatility of volatility itself. The markets, it seems, now have an
added dimension of risk."

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