Varoufakis on the Limits of Probability Mathematics, Conservative Orthodox Economics

“In a masterpiece entitled Science and Method, Henri Poincaré had warned back in 1914: ‘Probability is the opposite of certainty; it is thus what we are ignorant of, and consequently it would seem to be what we cannot calculate. . . . Among the phenomena whose causes we are ignorant of, we must distinguish between fortuitous phenomena, about which the calculation of probabilities will give us provisional information, and those that are not fortuitous, about which we can say nothing, so long as we have not determined the laws that govern them.’ In short, no one can possibly claim to know the chances of a financial crash while ignorant of its underlying causes.

How then did the economists convince the world, and the Nobel committee, that they could estimate the probabilities of events that their models assumed away not just as improbable but, in fact, as untheorizable? The answer lies more in the realm of rhetoric and psychology than in economics itself: they relabeled ignorance and marketed it successfully as a form of provisional knowledge. For instance, when unemployment seemed stuck at, say, 5%, and economists had no plausible explanation to offer, they called it “the natural rate of unemployment.” No need to explain it — it was “natural”! Or when they could not explain the deviations of human behavior from their predictions (e.g. in laboratory experiments), they (a) labeled such behavior “out-of-equilibrium strategies” and then (b) assumed that such behavior is random and “explainable” in the manner physicists describe white noise.

This thinly veiled form of intellectual fraud (i.e. the whole of what passes today as modern economic analysis) provided the “scientific” fig leaf behind which Wall Street tried to hide the truth about its “financial innovations.” The basic truth that Poincaré had exposed being willfully ignored, the three decades that led us to the Crash of 2008 coincided with the rise of a Holy Trinity that permeated all economic wisdom: the Efficient Market Hypothesis (EMH), the Rational Expectations Hypothesis (REH), and the so-called Real Business Cycle Theory (RBCT): impressively marketed theories whose mathematical complexity succeeded for too long in hiding their feebleness. Let’s take a glancing look at each one:

EMH: Financial markets contrive to ensure that current prices reveal all the privately known information that there is. In effect, no one can systematically make money by second-guessing the market. Some market players overreact to new information, others underreact. Thus, even when everyone errs, the market gets it “right.”

REH: No one should expect a theory of human action to predict well in the long run if it presupposes that humans systematically misunderstand that very theory. Sounds good, doesn’t it? A bullet between the eyes of patronizing social theorists who believe that they are closer to the truth about your behavior and mine than we are. Ay, there is the rub, for behind the façade of an anti-patronizing hypothesis lies a seriously insidious assumption: when people predict some economic variable (e.g. inflation, wheat prices, the price of some share), their errors are random — untheorizable, unpatterned, uncorrelated.

It only takes a moment’s reflection to see that anyone espousing EMH and REH cannot possibly expect recessions, let alone crises. Why? Because recessions are systematic events. However surprising when they hit, they unfold in a patterned manner, each of its phases being highly correlated with what preceded it. So, how does a believer in EMH-REH respond when her eyes and ears scream to her brain: Recession, Crash, Meltdown? The answer is: by turning to RBCT for a comforting explanation. So, here it is:

RBCT: Taking EMH and REH as its starting point, the theory portrays capitalism like a well-functioning Gaia. Left alone it will remain harmonious and never go into a spasm (like that of 2008). However, it may well be “attacked” by some “exogenous” shock (coming from a meddling government, a wayward Fed, heinous trades unions, Arab oil producers, aliens, etc.) to which it must respond and adapt. Like a benevolent Gaia responding to a large meteor crashing into it, capitalism reacts efficiently to exogenous shocks. It may take a while for the shockwaves to be absorbed, there may be many victims on the way but, nonetheless, the best way of handling the crisis is letting capitalism get on with it, without being subjected to new shocks administered by self-interested government officials and their fellow travelers who pretend to be standing up for the common good.

In a sense, each of the three hypotheses is a different incarnation of a touching faith that markets know best, both at times of tranquility and in periods of crisis. You and I may think that this is just madness, but it is a lot more than that. At the political level it is the rationale behind powerful forces ranging from the Tea Party to the Bundesbank, from the UK coalition government’s self-imposed austerity to the austerity imposed upon the Greek government by the IMF-Eurozone-ECB troika. This dangerous self-delusion is founded on a hidden analytical bond: each tentacle of the EMH-REH-RBCT nexus presupposes that for the price of every different type of financial asset there exists (what statisticians refer to as) a unique sufficient statistic. One that the market converges toward, albeit in a noisy manner. But, as Poincaré knew, it is pure folly to presume that such unique statistics exist without first having established the laws that govern the determination of prices. And since in capitalist societies these laws are radically indeterminate, the very foundation of the EMH-REH-RBCT nexus is rotten to the core.

Anyone who brings a fresh pair of eyes to the EMH-REH-RBCT nexus should arrive very quickly at the firm conclusion that it is a childish theory upon which to found an analysis of capitalism. And yet it condemned a whole generation of economists to thinking of the most complex, disintegrated, precariously balanced period in the history of capitalism, the 1971-2008 period, as the era of an equilibrium-bound Gaia gallantly and successfully working out of its system all externally induced non-economic shocks.”

Varoufakis, Yanis. 2010. “The Econobubble Revisited.” MRZine, October 26.

Varoufakis continues on to describe how this piss-poor “science” was widely marketed because it supported the US’s post-1970 political-economic strategy of expanding budget and trade deficits, and paying for them with capital inflows from the rest of the world (see also Dumenil & Levy).

Luckily for us, Varoufakis is on a roll…

On Oct 23, 2010, Varoufakis gave a great radio interview with Doug Henwood on the current unfolding of the capitalist crisis.

On Oct 17, 2010, Varoufakis published (with a nod to Marx & more recently, Zizek) “First as History, Then as Farce: The Euro Crisis Revisited,” at MRZine.


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