Assessment of Game Theory

At best, game theory predicts reality in the same way as “The Emperor’s New Clothes” predicts the future political path of Yair Lapid. (Israel's Minister of Finance)

How game theory will stop Iranian nukes
I've devoted most of my life to economic theory and game theory. I believe that I would like to do some good for humankind and, in particular, for the people of Israel.
by Ariel Rubinstein for Haaretz.
(via Steve Keen on Twitter).

Game theory is mentioned often in economic circles, to some extent it held out hope of making economics a science by replacing outdated and entirely erroneous assumptions about consumer behaviour. I'm very doubtful about the use of these hypothetical and abstract models for predicting real human behaviour.

Rubinstein, who has studied game theory for 40 years, confirms many of my suspicions:

Nearly every book on game theory begins with the sentence: “Game theory is relevant to ...” and is followed by an endless list of fields, such as nuclear strategy, financial markets, the world of butterflies and flowers, and intimate situations between men and women. Articles citing game theory as a source for resolving the world’s problems are frequently published in the daily press. But after nearly 40 years of engaging in this field, I have yet to encounter even a single application of game theory in my daily life. [my emphasis]

Like the use of quasi-medical Latin terminology in translations of Freud's vernacular German (e.g. ego for Ich) the fact that game theory is presented in formal mathematical language "creates an illusion that the theory is scientific."

"some have recently contended that the euro bloc crisis is like the games called Prisoner’s Dilemma, Chicken or Diner’s Dilemma. The crisis includes characteristics that are reminiscent of each of these situations. But such statements include nothing more profound than saying that the euro crisis is like a Greek tragedy."

Steve keen merely says "Realistic assessment." At the end of the article Rubinstein confesses that his first choice for a title for the article was "Why game theory doesn’t solve the problems of the euro bloc and won’t stop Iranian nukes" but he thought it might put people off.

What does "Economic Recovery" mean in the present.

The 2013 GDP estimates were out this week. 0.3% growth for the quarter is OK for an economy in crisis. Hardly a vindication of the coalition government's economic acumen, but it might have been worse. However the figure is historically low.  During the 1990's for example quarterly growth averaged about 0.65%.

The pattern of recessions in the past was that a relatively brief period of contraction was followed by above trend growth that returned the economy to trend. We can see this in NIESR's chart showing the path of recession and recovery in various previous downturns, updated for their estimate of monthly GDP, published March 12, 2013.

from Not the Treasury View

The black line is the present. What it looks like is that zero growth is the new trend. Indeed there was growth in the period 2009-2010 that looked like a recovery, but since then growth has averaged about 0.04%. With margins of error this is zero. Though I have yet to find a margin of error figure for GDP estimates, the figures are stated to the nearest 0.1% and anything less that that is probably noise.

And why is growth so low? Well it's widely acknowledged to be because demand is low - both consumer and business, in the UK and Europe. Now why demand is low is the subject of debate, but those economists who take note of levels of private debt point out that it is still high. Household and business debt are very high. Thus spending is low while people pay off their debts.

To be sure, other people are saving and have piles of cash or capital waiting to be invested. But while demand remains stubbornly low it doesn't make good business sense to invest. Because effectively what is meant by "investment" is an expansion of supply of goods and services. And when demand is low it is counter-intuitive to argue for increasing supply. So an investment led recovery is a non-starter.

Though of course the government have been banking on this for 3 years now. Indeed the government are keen to make the banks lend more. But with so much debt in the system, and the disastrous results from too much debt, the banks (newly sober) are reluctant to lend. Lending to business in a chronically depressed economy is a high-risk enterprise. So even with a great deal of carrot and stick government has failed to get banks to lend more. A debt led recovery is also a non-starter.

Ideally consumers would start to spend more and demand would rise and everyone would become optimistic and start investing again. But this is wishful thinking. Consumers as an aggregate have very high debt levels. What's more real wages are falling at present. So a consumer led recovery is also a non-starter.

What's left? There really is only one sector of the economy that can invest under the present conditions. That is the government. If the government continue to pursue austerity and make only token gestures towards investment then nothing is going to change. Indeed rather worryingly the reduction of debt stopped in 2012. Debt levels in the private sector remained static at 440% of GDP.

So the way things are looking zero growth will be the new trend. Some people have described this as a plateau, but really this is a valley floor - we're still below the peak of 2008. And we're bumping along the bottom. Present government ideology driven economic policy is now widely perceived outside the Treasury to be harming the economy. Even that bastion of monetarism, the IMF, is having second thoughts about the austerity that has crippled Europe and the UK. While the mainstream continue to ignore the role of private debt in the economy nothing much will change.

Steve Keen at INET

Professor Steve Keen recently spoke at the INET conference. It was a short talk, but full of his usual gems. His talk starts at 20.45 (I can't seem to embed with a time reference).

Notable quotes

"Workers pay for higher [private sector] debt via a lower shares of wages."

"Inequality leads to economic collapse"

"The most important driving force in a capitalist economy is private debt."

Spending vs Investing - updated

There seems to be some confusion amongst people who comment on news articles online and politicians about the distinction between spending and investing. Thus when the people say things like "So in a nutshell, what will you do? Spend or not spend?" it completely overlooks the other possibility.

We spend money when we get what we pay for and nothing much else. However the govt is in the enviable position of getting multipliers. As it spends money on welfare, those receiving the payments spend almost all their welfare in the real economy - on rent, food and basic services. This helps to keep money flowing through the economy - like cash flow in a business. And since tax is paid on what is earned and spent a lot of what they spend comes right back to government, to go through the system again.

Investing is a totally different proposition. If I invest in building a house I pay the money up front but then I sell the house at a profit once it's built. Building houses in the UK is very profitable because houses sell for about 5x what they cost to build. You spend £50,000 and sell the house for £250,000. This is the essence of capitalism - investing capital in order to make a profit. And that £50,000 is also spent - so a lot of it goes through the same cycle as other spending and comes back to the govt as taxes.

The IMF have confirmed that the major contribution to government borrowing at present is reduced revenue due to the depression. Demand for goods and services has dropped off dramatically so that the economy is now hovering around zero growth (with a few ups and downs). Thus tax revenues have fallen off and the government has spending commitments which it must meet by borrowing.

The present government has a strong ideological commitment to allowing the real economy ('the market') to take care of themselves and to reduce spending by making cuts. They have made minimal attempts to encourage lending for investment but these seem to have been in ignorance of the massive debts held by the private sector (despite this information coming from government Budget Reports - esp 2011 and 2013).

The other option, the one that the Chancellor had built his hopes on was that part of the private sector is sitting on a large surplus. This surplus capital is of a scale that if it was invested it would stimulate the UK economy. However while demand is low investors are rationally and understandably reluctant to risk their capital, and more or less unable to borrow to invest as banks see the same economic conditions as making loans risky (this is aside from the fact that the banks created this problem by lending too much money in the first place).

In addition the government's austerity policies (again according to the IMF) are depressing demand in the short term. While demand is low the private sector cannot (because of too much debt) or will not (because of too much risk) invest in the UK economy and we stagnate. And this will simply go on until the levels of debt fall low enough to make an impact on demand. No one knows how long this will take. The March figures from the ONS show that household and private sector deleveraging is more or less stagnant - we stopped paying off debts in 2012. So the process could take a very long time indeed.

And what is more, while the private sector is running a surplus (hoarding money) the government must run a deficit (i.e. must borrow more than it earns, ratcheting up the national debt). What we need is the converse - the private sector running a deficit - borrowing to invest and making profit - and the government to run a surplus (paying down debt with the extra as well as investing in infrastructure).

The govt is the one with the power to take a different path - to move more decisively from spending to investing. It can borrow at much lower rates than the private sector over longer terms and has a huge asset base so the risk is very low. There is risk of course, but the is greater risk from the current strategy of austerity and inaction.

The failure on the part of the public to distinguish between spending and investing has been exploited by the government to pursue their ideologically driven policies. They won't borrow and spend as they say, but in this they include borrowing for investment as though spending and investment were exactly the same. Their investment program is far too small to make any difference. Plans to invest more always involve spending less in other areas. The extra investment is too small, and the impact on demand of less spending is far more significant. With investment lumped in with spending the government is able to maintain minimal support for their policies - though cracks are beginning to show.

Beyond the present government it's not clear whether Labour, the current opposition, are any more able to make the distinction and exploit it than the Tories and their LibDem sidekicks are. labour have said they would cut less, but not whether they would invest more.

National Accounting

In his excellent blog on national accounting, Edward Harrison makes the point that when the private sector is in surplus the government must run a deficit. Very clear evidence of this can be found in today ONS Economic Review for March 2013. By regraphing chart 4 we can see the inverse relationship between public and private finances. At present the private sector are running a large (but diminishing) surplus. And the government is not saving but borrowing. This graph only shows from 2008 onwards, but it is striking how closely these two amounts mirror each other.

Harrison argues (from the Austrian school of economic thought) that the sum of the sectoral financial balances must net to zero. And he points out that a government deficit is an effect of activity in the private sector, not a cause. 

"Budget deficits are the result of the ex-post accounting identity between the sectoral balances and should not be a primary goal of public policy."