Against The 70s

Someone not so recently asked a big question, "Why does the 1970's inflation matter so much to economic thought?". There are so many stories told about that period that it has passed into myth. It isn't really clear why, at least if you look at it through the lens of high powered macroeconomic theory. Supposedly it all has something to do with the Phillips curve. The Phillips curve is an expression of the observation that the rate of inflation is negatively correlated with the rate of unemployment. The Phillips curve hypothesis is that this correlation is stable (at least, holding institutions constant) and that the order of causation can run from inflation onto unemployment. The usual story is simplistic: "Back then we believed in the Phillips curve, but the 70's taught us not to do so.". That sound you hear is a vortex generated by philosophers of science rolling their eyes.

When you try to put meat on these bones, you find they break too easily. It isn't easy to find a high flying macro theorist who actually believed in a stable, exploitable Phillips curve. The classics certainly couldn't believe in such a money illusion; Keynes couldn't have argued for a stable inflation/unemployment trade-off (if it existed, why would we need G > 0 ?); Samuelson and Solow certainly didn't believe in it; nor did Fed Chairman at the time Arthur Burns. It's hard to find a single person that "believed" in the Phillips curve in the way it is said to have been.

Milton Friedman

These facts - and they are brute historical facts - have led some to believe in a conspiracy theory of the 70's. "Milton Friedman and the Chicago School convinced everyone that the 70's 'proved Keynes wrong because the Phillips Curve was wrong!1!' was all a lie and therefore modern macro is an illusion meant to disguise naked power grabs by The Enemy.". I put it in a way that you could see how fallacious such reasoning is, but I've seen it put almost as bluntly before.

It is strange, you have to admit, that such brilliant people would be snookered by it. Not just right wing radicals who want validation came out of this. Ed Phelps, Stanley Fischer, and Tom Sargent all saw ... something invalidated. But if it wasn't the Phillips curve, what was it?

Stevie Nicks

The first thing that you have to realize about the 1970s is that it was not, in fact, the 2010s. Nobody in 1976 - not Nixon, not Friedman, not Samuelson and not anyone in heterodox economics - was also in 2016. Everybody was groping blindly and if some had more insight than others, well we should be so lucky. The other thing to realize is that high falutin' macro theory is a tiny and rare thing. Nixon certainly never read a single work in the field and didn't have any friends that did. Ed Cole - one of the presidents of General Motors - could tell you a lot about the Chevy Corvair or Vega, but knew and needed to know nothing of the debate over large scale statistical models and certainly he had no opinions worth noting on anything as abstruse as the Cambridge Capital Controversy that was so distracting in the 60's. This is interesting given how macroeconomic his job was. Some basic facts from Wikipedia: GM at its height measured its profits in % of GDP. GM was the second largest employer in the world - behind only the entire Soviet state.

So, given that Cole was no expert in high macroeconomic theory for its own sake, what did he believe? Clearly, I can't read his mind. But I can give you a picture of what he likely believed, even if he would quibble with a nibble or two. If you are a fan of brief summaries, I'll give you one: "He thought he lived in the era of Mad Men.".

John Kenneth Galbraith

The person who most clearly put the vision to paper is J K Galbraith in his books The Affluent Society and The New Industrial State. Since this vision failed, it might seem that I came to pick on him, but I actually a lot of sympathy for him. He was trying his best and had a basically empirical outlook. He was basically right on backing imperfect competition. Even if he went too far and replaced it with something equally simplistic, Galbraith was right to question consumer sovereignty. He worried about the structure of the firm and capture of government legislation by business before it was cool. Galbraith was trying to think through ideas that don't formalize very easily. He was trying to get away from the myth of the rational consumer. Herbert Simon was working on similar ideas and did better work, but never anything macro related. Galbraith tried his hand and if he didn't succeed, well, did anyone?

Carlo Ponzi

Galbraith's method is developed in his second book, The Great Crash, 1929. This is a strange book for a modern to read. The first thing one notices is how little a role the year 1929 plays. The lengthy, hilarious section on the Florida real estate bubble is the best part of the book - but what all does it have to do with the Great Depression? This part of the book is an argument - I don't remember if it is explicit or implicit - that the market is not guided by rational consumers. The masses are irrationally attracted (that is to say, they will invest more than they would expect to receive if held down and forced to think it through) to the promise of easy money, even if it comes from Carlo Ponzi or Donald Trump. They are irrationally repelled by the slightest loss. They put good money after bad. They're moved by emotional displays from the wealthy. They do many things, but they do not maximize net present value like Irving Fisher taught us.

Sigmund Freud

Though the masses are not very good consumers, the advertisers and engineers, they're very good (supposedly). From this vision, the corporation emerges as the fundamental entity of economics. A corporation consists of four parts (my typology, not his): the capitalist, the engineer, the laborer and the advertiser. The advertiser has read his Freud and empirically studied the deep parts of human nature. As depicted in Freud On Madison Avenue, the advertiser designs the aesthetics of the car to be a giant phallus with a clitoral emblem on a vaginal grille. He can then determine exactly how much the irrational consumer will buy in aggregate. The engineer then designs the car as a functional item, which selects the costs of production. The laborer and capitalist then build the cars. The income is then divided among the four parts of the corporation by the labor contract (which is fixed by negotiation between the capitalist and labor, which in practice is represented by union officials). Note that it is not the profit that is divided, but the income. That doesn't matter in this system - income and profit are jointly decided by the engineering and advertising experts. The corporation never has to worry about society wanting less products in general, demand will be simply created by the government if it ever accidentally slackens.

There is much to criticize in the above system. The biggest problem is a very strong difference that is assumed to exist between the irrational common consumer and the tiny echelon of experts that control them. There's no way to get around this, there should be no apologetic for it and there is no question into which class Galbraith put himself. It is assumed, not proven. When pushed on this point, Galbraith would fall back on his endless supply of jokes about irrational consumers. In his economics and his novel, this was all but explicit. The only question was whether people Galbraith would be allowed by his fellow elites to make the masses a comfortable world. There is no freedom to give them.

The role of the state is very strong in Galbraith's mind. I've already mentioned maintaining demand at a full employment level. Another is managing labor unions. The labor unions face a macroeconomic prisoner's dilemma. Imagine two labor unions that have the choice of either asking for higher wages or keeping them stagnant. If they both keep stagnant, then the price level stays the same and everyone is well off. If just one asks for an increase, then its members are much better off. But if both ask for an increase, relative wages stay the same but the money price of everything goes up. Therefore, people are worse off. (This actually happened in England in the 70's) This is one of the state's tasks as countervailing power against the large corporations (and their unions). The simplest and most dangerous way of doing this is wage controls - Galbraith never bothered to ask for another one. Price controls in general follow from the same argument on advertisers instead of laborers.

 Panasonic Space Age Television

Outside of the secluded world of high economic theory, much of what I just exposited was uncontroversial. Arthur Burns, the head of the Federal Reserve at the time, believed much of it. Galbraith's books were best sellers. Further, it was in the general culture. To be an adman in the 60's was to be the king of the world.

What happened in the 70's was the fall of the whole idea. For the first time, the mandarins in charge were forced to admit that demand management was non-trivial. The incoherent system of monetary policy, price supports, unpredictable government regulation and massive war time spending interacted with oil-induced supply shocks and changing culture demand shocks to pull aggregate demand in every direction. The net result was gas queues, stagflation and malaise. The role of the failure of price supports, while not shocking to any theorists, bolstered Friedman's claims that markets were a necessary part of demand management (he didn't put it like this). Friedman prestige didn't come from just getting it right, it came from how he got it right. No high powered macroeconomist denied the possibility of stagflation - but Friedman happened to have the perfect combination of being against price supports, for rule based monetary policy, for smooth government regulation (okay, I'll be fair. He was against government regulation in general) and having done deep work about how the economy can smooth over shocks. It was exactly what people needed in 1971 (well, government regulation in general is arguable, but certainly not basically arbitrary price controls).

The markets upset the Galbraithian vision in a deep way. Recall that GM's deeply learned advertisers decide on how much sales they make this year. The human mind cannot resist the sexual allure of their automobiles ... supposedly. But the oil crisis meant that people wanted smaller, more efficient cars, not rolling slabs of steel. The Japanese entered the automobile market with cars that people wanted and GMs sales declined. Wasn't GM supposed to control sales?

Another example. When GE designed a television, they decided the sales. They knew - knew - what people wanted in a TV: they wanted a wood exterior and a durable stainless steel frame. They wanted furniture (I know they thought this, because I've talked with the people who built them at the time). When Japanese companies started exporting cheaper, lighter all plastic televisions, GE was sure no American would want one. As it turned out, those "irrational" consumers resisted the psychological allure of the expensive American furniture and just bought cheap, functional boxes. This is not how the system was supposed to work! Didn't these consumers know that they were irrational?

The important thing about the 70s is that they seemed to show that irrationality could only be pushed so far. Consumer preferences can't be written off as a minor addendum. The point of Friedman about inflation expectations in the Phillips curve is minor. People had been writing about inflation expectations since monetary analysis began. What was influential was his whole approach. It was part of a general tendency to move toward rationality - game theory began to go deeper into traditional economic realms (such as industrial organization). And damn it, if you presume consumers act basically according to their preferences, then price controls and shocks cannot coexist. Friedman and others hammered on these points as far as they could. And then they were pushed even further...

You see, through the lens of the 70s experience outlined above, purely rational expectations economics starts to look good. However, once the "t"s were crossed and the "i"s dotted, the New Classical school that supposedly took them as their basis didn't live up to its promises. I mean this explicitly - they promised to pass statistical tests that they did not. The New Classicals stopped using these statistical methods because "they were rejecting to many 'good' models". Perhaps this movement toward "rationality" was itself irrational. In many ways, by the time the 80s ended, the rationality revolution of macroeconomics was spent. In other fields (the aforementioned industrial organization, for instance), the move to rationality bore better fruit.

Even with all these qualifiers, it was still the 70's that forced people in power to consider the consumer as an autonomous human being. And that is why it looms so large in our thought.

Classical Thermodynamics From "Intuitive" Symmetries? Part 1

In my last post, I promised to talk about Paul Samuelson's paper "Conserved Energy Without Work Or Heat". Now I will do so. Even earlier I had earlier promised a post about Disney Princesses. While I have a variety of observations, I haven't yet put them together into a theme.

First, a word about our author.

P Samuelson

Paul Samuelson is one of the father's of modern economics. Even more than with more famous economists like Keynes or Friedman, one can divide economics into a pre- and post-Samuelson quite easily. Paul Samuelson's most important work was his dissertation, Foundations of Economic Analysis. In that book, he provided perhaps the first completely mathematically clear explanation of what it is economists where doing. When an economist says that, for instance, a given tax is good or bad, what he or she means is that changing something given, the rest of the economy will eventually adjust and where it will settle will be better or worse than where it is now. A good example (with applications to finance) can be found here - and in innumerable other places! Samuelson made many other advances in almost every area of economics. Much can be said about his "scientific personality". He considered himself a child genius well into his 80's. He was immensely concerned with every aspect of scientific work, empirical, theoretical, philosophical, historical and pedagogical. Unlike many economists of his stature and influence, Samuelson almost never outright dismissed an economist or an economic theory, always describing them as containing nuggets of truth - of course, truths that he himself has formally obtained. His scientific ideal was that of classical thermodynamics, where the foundations were clear, the applications enormous and the empirical validity impeccable. Some have objected to his appreciation for classical thermodynamics, but most of these complaints are ill founded. To the extent he was inspired by classical thermodynamics, classical thermodynamics is inspiring. (Aside: it is not at all correct to believe that just because pre-Samuelsonian economists mostly used geometry and post-Samuelsonian economists mostly used algebraic notation that one was less mathematical. J.C. Maxwell's Theory of Heat was written almost entirely with geometry, and this example can be multiplied.)

Now on to the paper itself. This paper has multiple goals. One is a slick derivation of deep aspects of physics (esp. thermodynamics) from a few qualitative empirical regularities. One is to present the argument that one could have - in an alternate universe - completely missed the deep connections of thermodynamics to Newton's Laws. I am going to play loose with language, sometimes I will say "amount of heat" and other imperfectly defined things in order to bring these ideas closer to everyday experience. If this confuses anyone, then I will do another version which I am more careful (or they can read Samuelson's original).

(Aside 2: This idea, in a loose philosophical way, might be connected to "microfoundations" debate economists sometimes talk about. If microfoundations can be seen to be like statistical mechanics, then macroeconomics is like thermodynamics. This paper would then be an example where a simple empirical regularity is all that is needed to establish deep economic laws, rather than investigation of the deepest parts of the consumer's psyche. This argument is unimpressive, and Samuelson would never have dreamed of making it, but you can think about it if you like.)

Now, on to the deep parts of the paper. The main empirical principle of this paper is that if you put two hot things in contact, then they will equilibrate. A cold drink will turn warm in the hot summer afternoon. This principle is purely qualitative, but quantitative measures will fall out of it. Notation will simplify things. Our Principle is that "The Temperature of System 1 and the Temperature of System Two go to the Equilibrium Temperature in System 1 and the Equilibrium Temperature in System 2.". This is a mite cumbersome. Instead we say \( (t_1 ; t_2) \rightarrow (t_eq ; t_eq) \). We assume that \(t_eq\) is a function of the initial conditions.

Brief considerations as to measurability of heat are given, but these are minor enough that the assumption that the only important conclusion is that the final temperature is to be a function of the initial temperatures. This paper is written as an alternate history past Carnot, so we aren't interested in chemical, gravitational, electromagnetic, etc forces (more on aside 2: one of the many arguments against the above aside is that one couldn't do this without "microfounding" heat. Is this true? Discuss.). We consider the effects of heat by itself.

A thought experiment. Consider a bowl of hot soup kept in contact with a container of cool apple sauce. The bowl and the container are strong, they do not melt or flex because of the heat. They are kept in a insulating lunch bag, so that they don't lose heat to the environment. A sort of drawing of this situation:

What will happen? By our principle founded on common observation, the substances will come to be the same temperature. Of course, there is more to consider than just the temperature. I drew the above as if the soup and apple sauce were in equal volumes, but if I had enormously more soup or enormously more apple sauce, then the one with enormously more volume would barely notice the change due to the other. There might be other dependencies, but Samuelson follows Carnot wisdom that the main action can be captured considering only the interaction of volume and heat - and sometimes heat alone! Symbolically: $$(t_1,v_1 ; t_2,v_2) \rightarrow (t_eq,v_1; t_eq,v_2)$$ $$t_eq = f(t_1,v_1 ; t_2,v_2)$$ The first part is read "The Temperature and Volume of System 1 and the Temperature and Volume of System Two go to the Equilibrium Temperature and Original Volume of  System 1 and the Equilibrium Temperature and Original Volume in System 2.". Obviously, this doesn't depend on how the apple sauce and the soup are oriented, since the bag is being thrown around all day anyway. This implies that \(f(t_1,v_1 ; t_2,v_2)= f(t_2,v_2; t_1,v_1 )\). Today, I will concentrate solely on what can be concluded from experiments of this type alone, but in Part 2 I will introduce a more complex experiment involving pistons.

These experiments can be compounded arbitrarily. For instance, we can put four substances together:

And the above reasoning still applies. The arrangement can be manipulated so that red and yellow equilibriate while orange and burgandy equilibriate, then those two are placed next to each other and the whole system is allowed to equilibriate. Alternately, the arrangement can be manipulated so that red and orange equilibriate while yellow and burgandy equilibriate, then those two are placed next to each other and the whole system is allowed to equilibriate. Either way, the system comes to the same temperature. It is easy to arrange the volumes (actually, specific volumes) to be the same. In this case we have the simple symbolic expression for the above: \(f(f(t_1,t_2);f(t_3,t_4))=f(f(t_1,t_3);f(t_2,t_4))\). It is read "The equilibrium temperature of the equilibrium temperature of the first two substances touching the second two substances is equal to the equilibrium temperature of the equilibrium temperature of the first and third substances touching the second and fourth two substance.". You can start to see why we invented this notation!

Now we add a couple new assumptions. These assumptions are unobtrusive and intuitive, but they might be wrong and must be stated. We have already extensively discussed the existence and symmetry of the function \(f \), which takes the system set up and gives the equilibrium temperature. We also assume that the function \(f \) has the property that if two substances have the same temperature, then the equilibrium temperature is that temperature. (more on aside 2: if we were interested in "microfoundations" right now, then this would be a statement about the nature of an equilibrium - namely that it is an equilibrium!) Otherwise, purely mental divisions could make physical changes. Finally, we assume that if you perform the same experiment, but you make one of the substances hotter before hand, then you always get a hotter equilibrium. It is these properties of heat, perhaps, that lead to the idea that heat was an independent substance!

These assumptions give a remarkable conclusion, the existence of a sort of energy function! Perhaps a better name would be a caloric function (this does not mean, of course, that there is any such physical substance!). A brief verbal argument can be made. I said before that the above that the latter assumptions make heat seem like a substance, since if you add more of it, more comes. The amount of that substance is the caloric. The equilibrium temperature is derived by averaging the amount of caloric in both substances (notice averaging, not summing. This becomes clearer when the mathematical argument is fully expounded). What is remarkable is the role of symmetry in the proof. If the function were not symmetric, we'd have no reason to think that the equilibrium temperature could be found by averaging equilibrium temperatures of partitions. It was this fact that is the foundation of this theory! By choosing references, one can convert this equation into a standard internal energy function. We have begun the battle of recovering classical thermodynamics from simple symmetry arguments.

Phew! I have covered much ground and only barely scratched the surface of this paper! I need to go through and show how this caloric function is found, give more examples, and there's a an entire second experiment! These posts will come every Sunday. If there's particular aspects of this argument that interest you, drop me a comment. Before I go, however, there are a couple things I would like to highlight. First of all, notice that we derived an energy function, but I didn't check anything about its form. For instance, I didn't make any assurances that it was always positive. It is this reason I prefer to call it a caloric function, even if I risk misinterpretation that this somehow vindicates the physical concept of caloric. More importantly, I want to highlight that this argument makes no reference to Newton's or Schrodinger's laws. Physicists have a deep rooted appreciation for the laws of thermodynamics, and it is arguments like these that gives substance to those feelings. No matter what the universe is like, the laws of thermodynamics will apply as long as those fundamental symmetries are observed. This does not establish that the laws of thermodynamics are universal, but a non-physicist might wonder why they are believed to be and arguments like this will help the intuition in that regard.

Finally, a social observation. The laws of thermodynamics are wildly misused in bad science, bad philosophy and even bad politics. I have seen irresponsible writers on the internet imply and argue that they make action on global warming impossible, often with naive importations into economics or politics. What I hope is that when reading this, you absorb some of the actual intuition of this science, rather than the slogans such people use. When someone claims an application of thermodynamics, check first to see if even first principles - such as these - apply. If it is not obvious how, then they are not obviously right. See you next week!