A Excellent Dialogue with Smiling Dave on His Blog

Dave, Thanks for sharing excellent thoughts. Our formal economics training heavily leans toward the Austrian school, so we are significantly aligned. A few follow-on comments have been added in this post. Your comments are in blue and our responses are in red and underlined.

They asked me for input, for which I am honored. I have some questions indicating I have not grasped what they are saying, and am hereby requesting clarification.  Quotes from anyone in italics, Smiling Dave in regular font.

1. Give & Take Economics redefines the model of how individuals make decisions. It replaces the idea that they solely balance external prices and quantities in a scarcity-driven trade-off with the notion that they make an internal psychological trade-off of how much cost they’ll bear to obtain benefit. On this intuitive foundation, decisions are modeled with a pragmatic Leaning X diagram. The theory goes much further however, to also redefine the way individuals interact with each other. It expands the classic supply and demand curves into give and take curves, which places all social agreements (including economic transactions), within this context of individuals mutually balancing personal total cost (PTC) and personal total benefit (PTB). [Source]

I’m not sure what exactly is new or different in their basic approach from that of AE [ = Austrian Economics]. Didn’t Mises already write that people act to better themselves, doing what they think will get the job done? Didn’t he already write that bettering yourself doesn’t have to mean have more money? Aren’t the concepts of opportunity cost and risk used all the time by Austrians?

We agree with you that Give and Take Economics heavily relies on Austrian economics and that opportunity cost, risk and non-financial motivations have been previously captured. Give and Take Economics drives things forward by replacing the entire ‘economic’ decision with an overarching internal psychological one. The balancing of prices and quantities becomes secondary to the balancing of personal total cost versus personal total benefit. Elements such as ego, personal biases and favoured relationships all significantly and directly impact decisions. Existing models do not capture this reality in their formal frameworks. Give and Take Economics does—formalizing it in individual decision-making via the leaning X diagram—and when people interact via give and take curves. The theory also significantly leverages the formal modelling of Cumulative Prospect Theory.

To illustrate the difference with an everyday scenario, consider a person deciding whether or not to embark on an exercise program. Contemporary theory would model this person’s decision as one where they faced outcomes of either weight gain or weight loss with various probabilities. In contrast, Give & Take Economics models this as a decision where the person faces a choice of how much ‘pain’ (certain & uncertain PTC) they are willing to take on in pursuit of ‘gain’ (certain & uncertain PTB). A person doesn’t face alternatives of either being thin or overweight; they face the alternative of being thin while having to avoid excess calories or that of being overweight and enjoying lots of great food. The decision isn’t across a ‘lottery’ of outcomes either good or bad. The decision-maker bears both the PTC (the effort required) and the PTB (improved weight on the scale) in each scenario – a concept we call matched outcomes.

2. This new framework has major implications. It makes equilibrium impossible and explains how booms/busts and fads/counter-fads occur—something that current theories can’t address.

I thought AE gives a very nice account of booms and busts. And their explanation is mysterious. All it says, as I grasp it, is that the lemmings decide to run in one direction, because they think they’ll make money, then decide to run in the other direction. I don’t see where there is any predictive value in this explanation.

AE, on the other hand, does predict business cycles, to a certain extent, in that it claims that whenever you get a huge increase in the money supply, a boom followed by a bust is sure to happen within a few years.

So my questions are, what do they see wrong with AE’s explanation? What is the predictive value of their explanation?

Austrian theory is very accurate in its prediction that money supply increases are the most prominent source of boom/bust cycles, however ‘capital structure lengthening’ does not hold up in today’s service driven economies. Give and Take economics explains the type of bubbles we do see in today’s real estate and equity markets; bubbles tied to greed and fear emotions rather than ‘fundamental’ financials. Give and Take economics predicts bubbles whenever rapidly higher risk levels are taken on. This can involve the printing of money, media buzz etc. Beyond boom and bust cycles, Give and Take Economics is able to predict success or failure of other social policies—in welfare systems, tax policy, crime and punishment etc. Many examples are provided at http://www.economicsreinvented.com/?page_id=19. It can also be used to predict much simpler individual situations—such as whether someone will be successful in losing weight etc.—by identifying the PTC and PTB associations that individuals make.

3. Rothbard critiqued this lemming theory long ago. May as well quote him, from America’s Great Depression:

OVEROPTIMISM AND OVERPESSIMISM

Another popular theory attributes business cycles to alternating psychological waves of “overoptimism” and “overpessimism.” This view neglects the fact that the market is geared to reward correct forecasting and penalize poor forecasting. Entrepreneurs do not have to rely on their own psychology; they can always refer their actions to the objective tests of profit and loss. Profits indicate that their decisions have borne out well; losses indicate that they have made grave mistakes. These objective market tests check any psychological errors that may be made. Furthermore, the successful entrepreneurs on the market will be precisely those, over the years, who are best equipped to make correct forecasts and use good judgment in analyzing market conditions. Under these conditions, it is absurd to suppose that the entire mass of entrepreneurs will make such errors…The prevailing optimism is not the cause of the boom; it is the reflection of events [=money printing]that seem to offer boundless prosperity.

There is, furthermore, no reason for general overoptimism to shift suddenly to overpessimism; in fact, as Schumpeter has pointed out (and this was certainly true after 1929) businessmen usually persist in dogged and unwarranted optimism for quite a while after a depression breaks out.[30] Business psychology is, therefore, derivative from, rather than causal to, the objective business situation. 

My question is, how do they reply to Rothbard’s critique?

Rothbard is a great economist, however, this critique shows why he is certainly not a psychologist, nor a historian. Economic decision-making is an element of psychological decision-making, which is also emotionally driven. Booms and busts are not ‘errors’. They are deliberate manipulation. It is completely rational to both start a hyped-up boom and to jump on to an ongoing boom attempting to profit, trying to bail out early. There’s an entire industry devoted to it – equity speculators. There is also a very good reason that optimism suddenly turns to pessimism—the instinct of fear. Market collapses are always faster than market run-ups. We all agree that the printing of money provides extra liquidity for speculation, and inflation in consumer prices and assets. This being said, it is likely true that Give and Take Economics adds less to our understanding of market cycles than it does as a broad framework to analyze and predict all social coordination issues.

4. It also produces a powerful tool that we can use to immediately determine the effectiveness of policies and institutions—coupling analysis—based on the notion that most social problems result from social coordination failure, where PTB and PTC are decoupled across individuals and populations.

I agree with this. But isn’t it a well known concept, what economists call moral hazard? In short, if you are gambling with other people’s money, you will take wild risks. My question is, what is new here?

Moral hazard is about risk and it is an element of decoupling. Decoupling includes risk and fully certain misallocations. For example, the entire concept of taxing income is a decoupling that we have all internalized as logical, even though it is not. If society needs all of us to ‘pitch-in’ to provide a service, such as policing, then the cost of policing should be distributed across citizens evenly. This keeps the cost of services associated with those that benefit. When costs are decoupled from benefits and funded disproportionately by some ‘other rich guy’. Costs for all social services escalate to out of control levels, like we see today, and the ‘other rich guy’ ploughs more efforts into lobbying for tax relief to counter. All because everyone is passing off cost to someone else, rather than paying their share.

5. Decoupling results primarily when populations disengage enough to allow the formation of powerful intermediaries (including government and business); a situation that has resulted in our current strained models of capitalism, socialism and representative democracy.

Indeed, the problem with socialism and democracy is that you give one group control of another group’s money. But how did capitalism get in that list? And why do you say capitalism, aka a free market, is strained? If you hang around the msies.org website long enough, you’ll see how govt meddling [an unfree market] is the underlying cause of economic strains.

Good points. In the real world, capitalism generally means private enterprise as opposed to government, which is very rarely the same thing as free markets. We have lots of private enterprise, but very few free markets in the world. Many industries have aggressive lobbies restricting competition against their oligopolies. A telling example was the sub prime debacle, where Wall Street—the ‘bastion’ of the free market—ripped off the rest of society by socializing costs and privatizing the gains. Give & Take Economics shows us that it will absolutely happen again, as few executives had to pay anything back or went to jail. Sure, many industries are competitive, but all the big ones aren’t. They generally operate with the government in their back pocket through professional lobbies. The reason we say that capitalism has eroded (we likely should have said free markets), is that business competition has given way in so many markets to competition by lobbying, litigation and acquisition of competitors. Whether government or business, once power is amassed it will be deployed for the benefit of those that hold it. Free markets are strained for this reason. It’s really no different than how unions distort the free market through amassed power.

Summing up, I think these guys have their hearts in the right place. I think they do identify many problems the main stream pooh-poohs. They are not the guys you’ll see Smiling Dave attack mercilessly, like the many hacks and frauds that abound. But I do think their theory, and certainly all their conclusions that differ from AE’s, have some ‘splainin’ to do.

We hope this helps ‘splain’ a little. We’re all proponents of Austrian Economics, and feel that Give & Take Economics is an evolution on that strong foundation. We look forward to reading futher posts.

Cheers,

The Economics Reinvented Team

www.economicsreinvented.com

 

 

 

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  1. Pingback: The Economics Reinvented Group Replied to my Article « Smiling Dave's Blog of Psychology, Economics, and Gentle Sarcasm.

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