Re: Paul D. on this year's Nobel

[James Juniper <James.Juniper@xxxxxxxxxxxx>]

Dear Ted,

When Carabelli and De Vecchi draw a distinction between sources of beleif and
reasons for holding a belief, they follow Keynes in applying logical analysis
to the rational principles of valid thought. People fall back on caprice, whim,
sentiment and convention to resolve situations of radical uncertainty. So I
don't think their argument contradicts what Keynes explicitly claims about the
"rational" way of dealing with uncertainty or what he explicitly says in A
Treatise on Probability about both rational beliefs and rational reasons for
holding beliefs.

I would suggest that most of your quotes on convention do not necessarily
contradict Carabelli and De Vecchi's position: if anything they reinforce it.
For example, while it may be true that "the conventional belief in the
stability and safety of a money contract" appears unreasonable, unfortunately,
there are no alternative assets available, which provide security against
inflationary dangers. By definition, indexed bonds are based on some kind of
commodity bundle and can only provide protection against movements in the price
of the bundle as a whole rather than against price movements of individual
components in the proportion in which they are utilized by a given enterprise
or against movements in the prices of the final output vector.

A similar observation can be directed at the quote regarding the vast majority
of investors who "know almost nothing whatever about what they are doing.  They
do not possess the rudiments of what is required for a valid judgment, and are
the prey of hopes and fears easily aroused by transient events and as easily
dispelled". In the absence of adequate information it is reasonable to be
swayed by hopes and fears, or by mob psychology. Similarly, it is reasonable to
adopt the convention that the future will be the same as the past when the
precise nature of any departure from the past cannot be pre-determined or
predicted.

The point you make about "rational speculation" has more force (although a
quick perusal of the literature on quantitative finance reveals that almost all
option pricing and GE asset pricing models are based on rational expectations
rather than on mispricing). But of course, it is this very discussion in the
GT, which has given rise to the orthodox literature on noise trading .
Typically, in these models, better-informed "fundamental traders" are
constrained or prevented from taking positions that might lead to  gains
through the long term correction of mispricing (e.g. by having their
performance as portfolio managers assessed over very short term horizons). Yet,
the very notion of a fundamental is questioned by those  who argue for
"non-ergodicity" (including myself, though on less familiar grounds). Without
this anchor, any justification for noise trading models would be eliminated.

I would suggest that the assumption of irrationality is not required to
discredit representative agent models of financial market equilibrium.
Investors can, on entirely reasonable grounds, be swayed in their choices by
sentiment and whim, or by what is loosely called "irrational exhuberance" (by
Alan Greenspan) and uncertainty aversion (as formalized in the orthodox
decision-theoretic literature: e.g. Grant, S. and Quiggin, J. (2001), "A
model-free definition of increasing uncertainty"
<http://ecocomm.anu.edu.au/quiggin/>). If these same concepts are applied to
real investment activity and not just to the pricing of financial assets, we
would find ourselves back in a Keynesian world, where levels of employment are
governed by fluctuations in aggregate demand. And that is all I have been
trying to suggest in my previous comments in this thread.

Cheers,

James

-----Original Message-----
From: Ted Winslow [mailto:egwinslow@xxxxxxxxxx]
Sent: Wednesday, 16 October 2002 9:27 AM
To: James Juniper
Cc: 'pkt@xxxxxxxxxxxxxxxx'
Subject: Re: Paul D. on this year's Nobel



James Juniper asked:

> Do you have actual citations confiorming the use by Keynes of the word
> "irrational" in the unquoted segments of the quotes by Keynes that
> appear
> below?

Keynes does explicitly use the word "irrational" to describe both
significant aspects of human motivation in general and "the money-making
and money-loving instincts" which constitute, he claims, "the main
motive force of the economic machine" in capitalism.

Even where the word is not explicitly used, however, what he does say
makes it clear that he is claiming that the beliefs and feelings
underpinning economic behaviour are frequently "irrational" in the sense
I'm attributing to him e.g. the association of the "the love of money as
a possession" with "deep instincts" and the characterization of it as "a
somewhat disgusting morbidity, one of those semi-criminal,
semi-pathological propensities which one hands over with a shudder to
the specialists in mental disease" makes the motive out to be
"irrational" without actually using the word.

In "My Early Beliefs," one of the two essays Keynes instructed in his
will should be published after his death, he claims "the view that human
nature is reasonable" is "disastrously mistaken" and substitutes for it
the view that "there are insane and irrational springs of wickedness in
most men." (X, p. 447)

In the case of the "money-making and money-loving instincts" as these
are embodied  in GT's "three fundamental psychological factors" - "the
psychological propensity to consume, the psychological attitude to
liquidity and the psychological expectation of future yield from capital
assets" - he explicitly uses it in connection with second factor and
uses synonyms for it in the case of the other two.

In the Tract (which reiterates the claim made in the Economic
Consequences of the Peace about the "instinctive" roots of the
motivation behind saving) he points  (IV, p. 55) to "the deep instincts
by which the love of money protects itself" as the source of a "violent
prejudice" on the part of rentiers against the capital levy, the
rational method of preventing the excessive growth of rentier wealth.
In his evidence before The Committee on National Debt and Taxation on 6
May 1925 (XIX, Part 2 pp. 839-855), he explicitly identifies these "deep
instincts" with "very strong irrational feelings." He also implicitly
uses "psychological" to mean "irrational."  "In so far as its [the
capital levy's] results would be worse than those of any other new tax,
I think that the ill consequences would be due to psychological rather
than to economic or technical causes." (XIX, Part 2 p. 841)  "The
capital levy is extraordinarily disturbing in proportion to its
magnitude - far more so than any other tax.  You are insulting, by it, a
set of very strong irrational feelings in men." (XIX, Part 2, p. 852)

In the case of "the psychological propensity to consume," the irrational
"purposiveness" Keynes elsewhere identifies as the "main motive force"
behind saving in capitalism appears most obviously in (iv) and (viii) of
the "eight main motives or objects of a subjective character which lead
individuals to refrain from spending out of their incomes." Motive
(viii) is "to satisfy pure miserliness, i.e. unreasonable but insistent
inhibitions against acts of expenditure as such." (VII, pp. 107-8)  Any
reasonable doubt that "unreasonable" might mean something other than
"irrational" is removed by the elaboration of the "purposiveness" set
out in (iv) as an attempt "to secure a spurious and delusive immortality
for his ['the "purposive" man's'] acts by pushing his interest in them
forward into time" (IX, p. 330) and by identifying (IX, pp. 260, 268-9
and 329) it and "pure miserliness" as aspects of "the love of money"
which, as I've just shown, he explicitly identifies with "very strong
irrational feelings in men."

In A Treatise on Money, he identifies the "chief" convention on which
the "psychological expectation of future yield of capital assets" of the
"vast majority of those who are concerned with the buying and selling of
securities" is based with "mob psychology" and "unreason." (VI, pp.
323-4)

This follows his claim that this "vast majority," in contrast to the
"best-informed" and "wisest" investors,

"know almost nothing whatever about what they are doing.  They do not
possess the rudiments of what is required for a valid judgment, and are
the prey of hopes and fears easily aroused by transient events and as
easily dispelled.  This is one of the odd characteristics of the
capitalist system under which we live, which, when we are dealing with
the real world, is not to be overlooked."

He then points out that this creates an incentive for the
"best-informed" and "wisest" to devote themselves to rational
"speculation" - "it may often profit the wisest to anticipate mob
psychology rather than the real trend of events, and to ape unreason
proleptically."

This is inconsistent with interpreting Keynes as holding that for the
"vast majority" "the reasons for holding a belief are always rational,"
isn't it?

I don't understand how the "sources" of a belief can be "irrational"
while at the same time the the "reasons" for holding it are "rational."
 From what you say this seems to mean that even though "sources" of
"conventional" beliefs are "irrational," they are held for the
"rational" "reason" of providing a "practical answer" to the question of
what to do in the face of uncertainty.  Is this what is meant?

This contradicts what Keynes explicitly claims about the "rational" way
of dealing with uncertainty.  It also contradicts what he explicitly
says in A Treatise on Probability about both rational beliefs and
rational reasons for holding beliefs,

"There is, first of all, the distinction between that part of our belief
which is rational and that part which is not.  If a man believes
something for a reason which is preposterous or for no reason at all,
and what he believes turns out to be true for some reason not known to
him, he cannot be said to believe it _rationally_, even though he
believes it and it is in fact true." (VIII, p. 10)

This is even more obviously so for beliefs which in addition to having
an irrational source are knowable with certainty to be false.  As I
pointed out, Keynes claims this is true of the beliefs produced by the
"chief" forecasting convention "which is to assume, contrary to all
likelihood, that the future will resemble the past."

> The "chief" convention, for instance, contradicts the fact that "the
> future never resembles the past - as we well know." (XIV, p. 124)  Not
> only will the future be different from the past, "it will be different
> from anything we could predict."  "We do not know what the [long run]
> future will bring, except that it will be quite different from anything
> we could predict." (Keynes, quoted  in Skidelsky, vol. 3, p. 33)

Keynes also has individuals make use of the convention where there is a
rational basis for predicting change i.e. he does not, as Carabelli and
De Vecchi seem to claim, confine the use of conventional forecasting
practices to decision making in the face of uncertainty (see XIV, p.
125).  An important example of this, one which illustrates the
potentially disastrous consequences as well as the irrationality of
"conventional" beliefs and behaviour, is found is his treatment in the
Tract of "the conventional belief in the stability and safety of a money
contract."  (IV, pp. 6-12)

Ted