When economists brush with death

The journey of Irving Fisher shows disequilibrium ultimately rules in the marketplace, just as in ordinary life. Economists owe the world a model that reflects this.

Irving Fisher (1867-1947) was a neoclassical economist. I say "was” not merely because he is dead, but also because he emphatically rejected the neoclassical approach after his "Near Death Experience” during the Great Depression.

Fisher was worth over $US100 million in today’s money when The Great Crash began. Unlike most economists, he was also an inventor, and he invented a predecessor of the Rolodex – the iPad of its day. He sold his invention to the predecessor of Unisys in return for shares and a seat on the board – and like so many others back then, levered his wealth by buying shares on margin.

Back in the heady ‘20s, a typical margin loan was levered 10 to one. Put down (in Irving’s case) $10 million and your broker would buy $100 million worth of shares on your behalf.

The magic of margin was that, if shares rose a mere 10 per cent, you doubled your money, turning $10 million into $20 million. The catch was that, if shares fell by 10 per cent, the broker could insist that you keep the value of your portfolio by adding another $10 million. If you didn’t have a spare $10 million, you were bankrupt.

But a 10 per cent fall in stock prices could never happen, could it? Fisher expressed this common confidence wearing his most well-known hat, that of a columnist for The Wall Street Journal. Taking issue with his 'bear' rival Babson, he wrote his now most infamous lines on October 15, 1929:

"Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months" (15 October 15, 1929).

Over the next week, as the market fell almost 50 points, Fisher continued to spout words of reassurance:

Figure 1: Fisher quoted in the New York Times, 2 days before Black Thursday


Then it plunged 40 points in one day – Black Thursday – and Fisher’s continued optimism moved from the back of the paper to the front, just behind the news of the biggest one-day fall in the market’s history:

Figure 2: Fisher in the New York Times on Black Thursday


In the midst of The Panic of 1929, Fisher even took his campaign against "the lunatic fringe” (as he called those who believed the market was overvalued) to the movies, in a Fox MovieTone News statement. saying the market would be certain to rebound.

Figure 3: The Dow Jones Industrial Index October to November 1929

By the end of November 1929, Fisher’s reputation was in tatters (as was his fortune). No-one wanted to hear from America’s once most famous economist any more, but he still desperately wanted to understand what had happened. Less than three years later, he wrote "Booms and Depressions: Some First Principles” which he refined in 1933 into the "Debt Deflation Theory of Great Depressions”. These works marked his break from essential error of neoclassical thinking: that the economy can be modelled as if it is always in, near, or tending towards, equilibrium.

His previous fame as a neoclassical economist emanated from his Theory of Interest, which extended the conventional tools of supply and demand analysis to the market for money. An essential aspect of that work was the assumption that the market was in equilibrium at all times. As he put it:

"The more fundamental theory of interest presupposes a stable purchasing power of money… In that case the rate is theoretically determined by six sets of equations or conditions: the two Opportunity Principles; the two Impatience Principles; and the two Market Principles. The last pair may be said to cover prima facie supply and demand:

"(A) The market must be cleared – and cleared with respect to every interval of time. (B) The debts must be paid."

His 1933 work identified this assumption of continuous equilibrium (not to mention the absence of defaults on debt!) as the fallacy that had led him astray. Disequilibrium was the rule in ordinary life, it was the factor that explained phenomena like the Wall Street Crash, and economic theory had to be based on disequilibrium:

"We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, toward a stable equilibrium…" Fisher said. "But the exact equilibrium thus sought is seldom reached and never long maintained. New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium…

"Theoretically there may be – in fact, at most times there must be – over- or under-production, over- or under-consumption, over- or underspending, over- or under-saving, over- or under-investment, and over or under everything else. It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will "stay put," in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.

Had economists built on Fisher’s Road to Damascus conversion, an entirely new economics could have resulted from the Great Depression, with disequilibrium rather than equilibrium as its organising principle. Instead, with Fisher ignored, the economics profession rebuilt itself around Hicks’s equilibrium interpretation of Keynes’s General Theory. By the time our modern-day crisis hit, equilibrium thinking was utterly ascendant in economics – and only heretics like me worked in disequilibrium.

However in the real sciences, disequilibrium became the rule – so much so that they don’t even use the term to describe what they do. A decisive break with equilibrium thinking came in 1963, when the meteorologist Edward Lorenz accidentally discovered what became known as chaos theory (and is today called complexity theory). The Wikipedia describes the motivation behind Lorenz’s work well:

"During the 1950s, Lorenz became sceptical of the appropriateness of the linear statistical models in meteorology, as most atmospheric phenomena involved in weather forecasting are non-linear. His work on the topic culminated in the publication of his 1963 paper "Deterministic Nonperiodic Flow” in Journal of the Atmospheric Sciences, and with it, the foundation of chaos theory."

Lorenz’s key discovery was that a relatively simple non-linear system could display incredibly complex behaviour: what became known as Lorenz’s Strange Attractor had 3 equilibria, all of which were unstable. Today, any scientist worth his or her salt knows that dynamics means not merely a transit from one equilibrium to another, but a complex "far from equilibrium” path.

Figure 4: Lorenz's Strange Attractor, with 1 equilibrium shown & the dynamics of a 5 per cent deviation from that equilibrium


Would that this wisdom had penetrated economics. Instead, the vast majority economists remain locked in their neoclassical equilibrium fetish, so much so that they deride anyone who dares challenge their equilibrium view of the world.

A recent instance of this was the response by the Canadian Neoclassical economist Nick Rowe to an excellent post by Dan Kervick on a blag called "Shamanistic Economics”. Rowe’s condescending tone is evident in his comment – as is his belief that "all roads lead to equilibrium”:

Dan: before writing about this stuff, you really ought to think about the difference between:

1. A system with multiple equilibria (aka "sunspot equilibria”) where beliefs about intrinsically irrelevant events can change which equilibrium is the outcome. (e.g philosopher Lewis’ book on conventions.)

2. A dynamic system with a unique equilibrium time path, where beliefs about that future equilibrium path are part of what determines the current outcome.
And a little bit of knowledge of game theory might help too, where players’ beliefs about off-equilibrium path play (counterfactual conditionals) are part of what determines the equilibrium.

Sigh. Economists like Rowe should instead think about the difference between stable and unstable equilibria, rather than simply assuming that all equilibria are stable. Their inability to realise that instability may be the defining feature of the economy, five years after the economic crisis began, is testament to economics being far more a religion than a science. As Dan Kervick stated in his reply to Rowe’s missive, this is a dereliction of the duty economists owe the world, especially after we are in a crisis that most of them didn’t see coming, and whose advice about a solution is justifiably described as shamanistic:

"You guys in economics are supposed to be empirical scientists, not philosophers. You are supposed to develop the a priori elements of your science only so that you can produce empirically testable models of the real world, and then bring those models to bear on the world we actually live in.

"You are also supposed to help develop techniques that are relevant to decision-making and government policy in having predictable outcomes. You need to map the terrain of the actual world in detail, so you can help others navigate through it. To the extent you want to give policy advice that deserves to be taken seriously, your focus needs to be on contingent reality, not a priori possibility.

"My criticism is that an awful lot of the policy advice we are getting lately is from theorists who are lost in the clouds of a priori models, and who don’t have a clear understanding of the structure of the actual economic order we live in, based on the functioning of actual, highly contingent and specific economic and political institutions."

If you’ll pardon a religious final word from me, Amen.

Steve Keen is a professor of economics and finance at the University of Western Sydney and author of Debtwatch and Debunking Economics.

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