"The Keynes Solution" by Paul Davidson (3) - Faults of the Old School, Ergodic Predestination

Image credit. Continued from here.

In explaining the foundational assumptions of the canon of classical economic theories - the very mental cathedral that Keynes called into question - Paul Davidson points out:

The basic - but not only- difference between these classical theories and the Keynes theory is how they treat knowledge about future outcomes of today's decisions. In essence, the classical theory presumes that, by one method or another, decision makers today can, and do, possess knowledge about the future. Thus, the only economic problem that markets have to solve is the allocation of resources to meet the most valuable outcomes for today and for future dates.

Paul Davidson, pp. 32 - 33

For markets to be efficient 

buyers and sellers must know the resulting value of all possible values [engendered by investment and other economic decisions] that will occur in the future.

p. 34

Adepts of mainstream economics, argues Davidson, work on the assumption of future knowledge but are not aware of it. They promote very serious conclusions on this basis, while being oblivious of the critical assumption and its preposterous content.

This idea also underlies the antitax, rhetorical question of Ronald Reagan: "Why should some bureaucrats in Washington know better than you on how to spend your income?" After all, if you "know" the future, you should be able to protect yourself and your family against any adverse future events, and, by your investment decisions in financial market securities, ensure your self sufficient retirement income to live comfortably for the rest of your life.

[...]

If we accept the assumption that self-interested decision makers reliably "know" the future, then their decisions made in a free, competitive marketplace will result in the best allocation of resources possible.

pp. 34 - 35

I must admit, ever since having turned free marketer during my student days in Cambridge, my enthusiasm would be accompanied by a subliminal dissatisfaction about my not being able to completely prove the validity of my new economic creed. I remember, I assuaged my academic conscience with a trusting feeling that once I was going to have worked through Arrow-Debreu, I would be in a position to demonstrate my conviction beyond reasonable doubt. Obviously, I was not aware of the ridiculously strong assumptions incorporated into Arrow-Debreu's equilibrium model:

Many of today's mainstream classical economists recognize that the Arrow-Debreu presumption of the existence of a complete set of markets for every conceivable good and service for every future date until the end of time is impossible.

p.36

When I learned of the problem in the early 2000s, like the mainstream economists, I quickly went for a resort - though, not for the absurdity of rational expectations, a theory assuming that from contemporary statistical data future outcomes can be derived - not really an abrogation of the original egregious premise. I placated my worries believing that equilibrium outcomes were constantly being approximated by markets, but never fully reached. However, this hardly left me with much of a theory to explain why the equilibrating process should keep working, irrespective of constant abruptions, which latter, incidentally, I construed to be a healthy feature of capitalism brought about by entrepreneurial "creative destruction." 

Anyhow, the classic assumption that the future is known survives in mainstream economics under the heading "ergodic axiom:"

The presumption that data samples from the past are equivalent to data samples from the future is called the ergodic axiom. 

[...]

Unless the future is known, today's market participants cannot make decisions that the future will prove were efficient.

p. 37

Paul Davidson stresses two implications of the ergodic axiom: (1) reliance by investment banks in their models on the idea of efficient markets led to their downfall in 2008. (2) The efficient market ideology amounts to a belief in a predetermined future path of the economy. Thus:

Logically, consistent efficient market analysis suggests that active government economic policies that interfere with free markets create an external shock to the system, By an "external shock," the efficient theory economists mean that government policy is equivalent to throwing something into the predetermined path of the economy, pushing it temporarily off its path into one involving more unemployment, resource waste, and the like.

An analog to this external shock concept would be if we threw a pebble that hit a swinging pendulum. The pebble would produce an external shock that momentarily pushes the pendulum off its swinging path into a more erratic one. Unless we continued to throw more pebbles, the effect of the one-time pebble external shock would wear off, and the pendulum would soon return to its natural swinging path as the ergodic law of gravity reestablished control over it.

If markets are efficient and not constrained by onerous permanent government regulation and interference, the reaction of participants in these efficient markets to any external shock caused by government policies will move the economy back to its predetermined efficient path, just as the law of gravity would restore the pendulum swing after the external shock of being hit by a pebble.

In other words, whenever government policies shock the economic system, action by rational market participants in a free market, in some unspecified time (i.e., the long run), will restore the system back to its predetermined efficient path by purging "the rottenness out of the system" (to use Andrew Mellon's elegant phraseology).

p. 40 - emphasis added

The whole originally Walrasian general equilibrium visualisation of an economy is bizarre in more than one respect, and perhaps even a conceptual impossibility, even though it works mathematically and as a propagandistic allurement.

How are we to make sense of the human condition and especially of human rationality in a model where everything happens at the same time?  If everyone knows everything relevant at whatever point in time it may be available, what is left of personal privacy and autonomy? What is left of the shortcomings, ignorance, for instance, or deceit, that define being a human? What about differences among people in terms of skills, energy, and motivation to form a view of what is relevant and how it needs to be processed? In parallel to time collapsing into a singularity, conjectures and varying degrees of awareness and conviction collapse into a uniform lump of truth. Clearly this model is not motivated by the desire to come up with an economically sensible solution; it is driven by the eager ambition to establish conditions for a clean mathematical solution.

The model lacks minimally satisfactory assumptions about the real world.

Continued here.