Politics & Economics


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I have been reading Daniel Kahneman’s book Thinking Fast and Slow. Kahneman is a psychologist who won the Nobel Memorial Prize for Economics in 2002 for his work on judgements and decision-making. With Amos Tevsky, to whom the book is dedicated, he developed prospect theory as an improvement on expected utility theory as an explanation of decision-making in economics. They had earlier proposed the heuristics and biases model of intuitive judgements. In his later work Kahneman has developed the idea that measuring well-being is problematic because there are two selves in play, an experiencing self and a remembering self, and they don’t agree, raising some interesting questions about the pursuit of happiness.

Two academic papers are included as appendices, but the book itself is written for non-specialists. The target is water cooler conversation and gossip. We are mostly good intuitive grammarians, but we are not good intuitive statisticians or logicians. In order to recognise our mistakes we need, Kahneman suggests, on the analogy with medicine, a set of precise diagnostic labels where the labels bind illness and symptoms, possible antecedents and causes, possible developments and consequences, possible interventions and cures. With these to hand, we can improve our recognition of errors and possible create counter-measures.

Kahneman proposes a two systems model of the mind. System 1, or fast thinking, is the intuitive mind. It operates quickly and automatically and without effort, generating impressions, feelings and intentions. However, it is also impulsive and impatient. System 2, or slow thinking, is who we think we are. System 2, is the introspective mind, the mind which consciously reasons. Introspection requires attention and effort but system 2 is lazy, possesses limited knowledge and makes mistakes. Most of the time it is content to endorse the impressions, feelings and intentions generated by system 1.

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What is the economy? The textbook answer is something along these lines: the economy is the system of production and distribution of commodities, with or without the use of money. I have come to think that this is somewhat misleading, because it seems to make two assumptions: firstly that the commodity economy is primary and the financial economy is secondary; and secondly that the commodity economy and the financial economy are integrated and that there is in fact a single economy.

The model pictured in the diagram (*)  doesn’t make these assumptions. There are three principal ideas being illustrated. The first is that there is only a loose interaction between the financial economy and the commodity economy. We think they are closely entangled, because many transactions are the exchange of money against commodity. But many transactions are not mirrored. Taxes, subsidies and welfare payments, and lending and borrowing are purely financial transfers which have no correlate in the commodity economy. The central banks’ ability to create and withdraw money from the financial economy is also a purely paper transaction and has no necessary connection to the commodity economy. Asset revaluation, depreciation, goodwill and provisions against future losses are arrived at by applying formulae and accounting conventions; they are more or less successful attempts to capture something that is happening in the commodity economy. The financial or paper economy is entirely an artefact.

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The mainstream consensus locates the root cause of the financial crisis in structural imbalances in the world economy, in what Federal Reserve chairman Ben Bernanke called the ‘global glut of savings’. I have also read a number of Marxist oriented interpretations that argue that crisis is endemic to capitalism and crisis is always the consequence of the over-accumulation of capital and the exploitation of labour inherent in the search for surplus value. If we look past the differences in the conceptual framework, these appear to be fundamentally the same analysis.

Here’s how I think this works for income inequality but the same logic applies in the case of trade imbalances, although the solutions are different. Increasing income inequality means that more money is flowing to wealthier households. But wealthier households eventually reach a level of income where they can’t or don’t want to consume more. The surplus over consumption goes into investments in hope of a higher return. A couple of things follow. Firstly, asset price bubbles develop as surplus funds are invested in assets such as property, stocks and precious metals. Secondly, levels of indebtedness rise. This happens because the downward pressure on potential demand for commodities is being accompanied by upward pressure on the potential supply as surplus funds are invested in new capacity. In order for poorer households to consume the output from increased production, wealthier households, via the banks, have to lend them the money. The link between the two is that the debt is often secured against rising asset prices, and you get something like the sub-prime mortgage market.

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