Rethinking Economics The Washington Consensus vs the Tokyo Consensus Background

On Tuesday 6 May 2014 I published a blog about “Shimomuran Economics and the Rise of Japan” on the Rethinking Economics website at http://rethinkingeconomics.blogspot.co.uk/2014/05/shimomuran-economics-and-rise-of-japan_6.html

On Wednesday May 28 I also published an “Update on Shimomuran Economics” on this site at
https://medium.com/@georgetaitedwards/update-on-shimomuran-economics-the-day-may-come-b0512dd899b9 and I copied that article into the Rethinking Economics website later on the same day. A student at UCL, Bendik Langfeldt, commented on my article by saying:
“So this article says that the causative link between BoJ operations and growth, crash, stagnation and deflation cannot be doubted, because of a econometrics exercise without even presenting it. Then it proceeds to advocate against the use of mathematics in economics. First of all, usage of CB to control the money supply is derived from mathematical theories. The few non-mathematic theories on the topic, such as Hayek’s Business Cycle theory argues exactly that the crash and stagnation would be the result. Somehow this guy managed to argue that we should continue with central bank stimuli, despite arguing that it also led to the crash and 30 bad years. He also ignored the massive issues in the South-East Asian countries in 1997, partly caused by inefficient central planning of credit. And that South-East China grew because of similar credit operations, well, the SEZs were a major cause of growth in this area, and saw no government interference. Economic history gives better lessons than this journal, that relies on one mathematical calculation, and still argues against mathematics in economics.” The purpose of this note is to respond to most of these criticisms.

Dear Mr Langfeldt,

Introduction

Your brief criticism covers in a very muddled way five major topics: First, it criticises me for referencing the now-proven predictive causative links between the various kinds of credit creation and economic results without presenting that research; second, it wrongly assumes, because I criticise the use of mathematics to construct neo-classical castles in the air, that I am generally against the use of mathematics in economics; third, it assumes I do not know the statistical origins of the purported relationships between Central Bank credit creation and the money supply, and the interesting but sometimes invalid work of Hayek; fourth, it assumes all debt has no merit, when the whole point of recent research is that government-created credit can be used for about six specific purposes, and four of these may be economically useful while only two of these are potentially damaging; and finally it wanders off (assuming that your reference to “this guy” refers to me) into a muddled mix of arguments which are too unspecific to summarise and respond to, but I’ll try. Let me take these criticisms in turn. 

The Granger Causative Links between the uses of credit creation and the observed results
A brief detour into the significance of the work of Sir Clive Granger seems appropriate. As his Wikipedia entry comments
“In 2003, Granger was awarded the Nobel Memorial Prize in Economic Sciences, in recognition that he and his co-winner, Robert F. Engle, had made discoveries in the analysis of time series data that had changed fundamentally the way in which economists analyse financial and macroeconomic data.” It certainly should have, but generally hasn’t. Most neo-classical economists do not seem to be sufficiently interested in checking the validity of their assumptions against the real world although, if they can find a couple of appropriate time series specific to their assumptions, Granger has gifted us with a procedure which may do that. It seems that most Granger Predictive Analysis is used for short-term forecasting of financial trends in stocks and shares where it does not always work because no system so far predicts turning points. Many of the models preceding the massive crash of the credit crunch were based on excellent mathematics inappropriately used. Clive Granger’s acceptance speech at his Nobel Prizewinner’s award ceremony points that out. Professor Richard Werner has checked the validity of various possible Granger Analysis predictive relationships between the time series of credit creation and its subsequent results”Š-“Šin his two books “Princes of the Yen” and “New Paradigm in Macro-Economics” he has used the relatively new technology of Granger Predictive Analysis to examine the statistical validity of many of the scared cows of neo-classical economics. I could not possibly quote in detail all of these results in the short article to which you refer, nor here, because the copyright laws prevent that, and I had thought and still think I have given sufficient information for any competent reader to look up the sources and verify the information I have only partially presented, which is the usual procedure in articles at any level. Please do that if you are sufficiently interested.

Professor Richard Werner’s book New Paradigm in Economics has been independently reviewed by six readers who have given it five 5-star reviews and one 4-star review”Š-“Šyou can access these at http://www.amazon.co.uk/product-reviews/1403920745/ref=dp_top_cm_cr_acr_txt?ie=UTF8&showViewpoints=1.

Furthermore, Richard has analysed the BoJ credit creation time series intelligently by identifying periods of different use and specifying the approximate turning points in the use of credit”Š-“Šthe Japanese high growth period, when credit creation was applied to productive investment; the speculative asset bubble period, when the BoJ oversupply of funds led to the Japanese asset bubble; and the economic doldrums period, when the Princes of the Yen sat on their hands and, because of the usual poor OECD advice and the wish to create structural Washington-consensus changes in Japan, a recession was converted into a pointlessly long depression, just as is currently occurring in most of the major economies of the West.

Incidentally, Werner is summarised in the Wikipedia entry as “a German academic, economist and professor at the University of Southampton”, who is” a monetary and development economist. He proposed the term quantitative easing, as well as the expression “QE2″ referring to the need to implement true quantitative easing as an expansion in credit creation.” Richard has modified monetarism to make it more valid”Š-“Šlook up the research reported in his “New Paradigm in Macro-Economics” and see.

The use of Mathematics in economics
I am very much in favour of the use of Granger Predictive Causality tests to determine whether there is (or is not) a useful predictive link between two economic time series. See http://en.wikipedia.org/wiki/Granger_causality. Mathematics can be used in economics like a spade, to uncover relationships, or like a torch, to try to blind others with your supposed brilliance. In my view there is far too little of the former and much too much of the latter in most economics writing because of the dominance of theoretical neo-classical economists. If you find in a local library or acquire any copy of the Economic Survey of Japan (the one produced by Japan’s Economic Planning Agency, not the “same-answers-for-every-country, Washington Consensus OECD reports) then almost every table and nearly every graph will illustrate how economics can be realistically used. I have four copies of the EPA’s Economic Survey of Japan to hand, the 1957-58 one (stamped as once the 1962 Property of the US Army War College) and the the ones from 1958-59, 1968-69, and 1986-87. The EPA’s Economic Surveys of Japan illustrate how economics can be practically applied. To pick four charts at random from the 1968-69 Survey (which is a 352-page page booklet, containing 237 tables and charts and associated discussions) Chart C34 on p33 graphs the sources of funds (internal and external) against their uses (equipment investment, inventory investment and financial assets investment) in major enterprises, Chart C120 on p118 is entitled “Relationships Among Equipment Investment, Productivity, Exports, and Sales of Iron and Steel Industry” while Table T146 on p 140 deals with the “Effects of The Introduction of Electronic Computers (Direct Effects)” and analyses these, stating the number of reporting companies, into the reduction in inventories, the curtailment in delivery periods, the saving on personnel expenses, other savings, etc, while Chart C183 on p182 graphs the “Trends in the Dependence on External Borrowing by City Banks and the Operation Ratios of Surplus Funds by other financial Institutions” while Chart 184 on p83 graphs the “Ratio of Loans to Small Businesses, Classified by Lenders.” 

There are three points to these observations: first, the Japanese Government is magnificently informed about the operation of their economy, while Western Governments, lacking an equivalent to the EPA, usually are not; second, the main use of mathematics in economics is often quite simple arithmetic, involving the calculation of flow-through funding of capital investment effects, capital output ratios, ratios of use to capacity, etc, and the more sophisticated (but sometimes, in the light of more recent Granger Predictive Analysis, often not reliable) calculation of Box-Jenkins or regression relationships; and third, economists can be enormously useful when their work is helpful and adds insights to what is happening by the interpreted observations of economic and industrial realities.

The problem, as usual, in economics is with the inappropriate use of mathematics to construct complex systems on the basis of simple but invalid assumptions. There is no point in pretending that neo-classical economics is a kind of mathematical sister science, akin to physics, when neo-classical economics is obviously worse at present at preventing pain than dentistry.

The Two Great Traditions in Western Economic Thought

There are two great traditions in Western economic thought. The first tradition, dating from the time of Adam Smith, consists of deriving economic results through detailed observation and inductive reasoning from the observed facts and data analysis. The second tradition, most highly developed in the 20th century with the development of mathematical economic models and more lately computers, is based upon stated propositions and deductive reasoning. These two categories overlap but they can be regarded as a “bottom up” tradition of building economics from observation and induction, arguing from the facts, or a “top down” tradition of setting out the stated assumptions and then developing detailed mathematical equations and computer models, arguing from the theoretical propositions. 

The first “bottom up” tradition relies upon observing what is happening, and building economic understanding on the foundation of the observed circumstances or measured data, arguing from the observations or the data to the economic theory. All the books, written in that tradition, start by observing the complexity of significant reality, then build up from these detailed real-world observations to economic theory by extracting the significant relationships from the complex messiness of the real world. The key economic text book which founded economics is like that”Š-“ŠAdam Smith, in The Wealth of Nations, among many other things, refers to the productive power of specialisation by referring to the workers in a pin factory, and commenting how, by breaking down the elements of production into their constituent parts, a few specialised workers can create thousands of pins a day when one man could hardly produce one pin per day on his own. Smith’s book is a major illustration of the major renaissance scientific method of learning by observation, extracting the particular principle from the general, and basing theory upon real-world, precise observation.

Smith is not alone because some of the greatest books about economics have been based upon observation and inductive reasoning, The one common factor in the work of Adam Smith, John Maynard Keynes, Osamu Shimomura, Kenneth Kurihara and Richard Werner is that they all belong to the first tradition in economics, of deriving valid theory from detailed observation. Smith in the pin factory; Keynes in his observation that labour markets, left to market forces, do not produce Say’s-Law full employment; Shimomura deriving the economic model of Japan from his observation of the productive force of investment credit creation in the USA from 1938-44, when America grew at an average rate of 12.2% pa (and perhaps also from his practical involvement in the South Manchurian Railway, where most of Japan’s post-war economic planners cut their teeth); the Japanese-American Kurihara examining and discussing the Japanese economic miracle in close-up while acting as the Fulbright Professor to Tokyo University in 1965, when he analysed and commented on the Shimomura model of the Japanese economy; the German-born and Japanese-fluent Werner in Tokyo (from when he was awarded the first 1991 Shimomura Fellowship from the Development Bank of Japan) for a decade, working from the Bank of Japan financial data about credit creation in Japan and analysing it into its three key functions of investment credit, financial credit and the presence (or lack of) consumption credit, and then proving the predictive linkages using Granger causative analysis”Š-“Šinvestment credit enabling growth, excess financial credit encouraging speculation, and the lack of Bank of Japan credit creation in the 1990s converting the recession into a depression; the work of all these economists is located in the great inductive tradition of economics.

But the second great tradition in Western economics is the “top-down” tradition. We can start from explicitly stated assumptions (which are usually initially accepted as “unreal” but often none-the-less argued to be “sufficient for our purpose” whatever that may mean) and then proceed logically from these to policy recommendations, using deductive reasoning and highly developed mathematics. If we assume logical consumers and investors are acting within perfect markets, using perfect information, in a world in which perfect information has levelled out local differences, then we can deductively arrive at economic models which appear to have great logical validity. This second tradition of neo-classical economics is very logically attractive and some would say that it has served us well. Keynes’ stated view of these mathematical models was that “we are one equation short.” And one of the greatest mathematicians of the 20th century, Kurt Godel, has mathematically proven that all logical systems are either inconsistent or incomplete. Neo-classical economics is very incomplete because it is built on the shifting sand of unproven assumptions. Many of its basic assumptions, and some would say nearly all of these, do not relate sufficiently to the real world.

Smith’s “hidden hand””Š-“Šthe idea that everyone, acting from the most selfish motives, helps everyone prosper by their selfish action, is obviously not true of many bankers and billionaires who may be more interested in maximising their private share of the wealth than maximal wealth creation. That hidden hand assumption applies across the whole field of economics, and it would seem it also may not generally apply to many politicians either, judging them by results.

Credit Creation has Many Possible Outcomes 

There are perhaps two major wrong assumptions in the monetarist foundations of neo-classical economics. The first is the assumption that money and credit is principally a neutral medium of exchange. It is not, because credit creation can either act in favour of production (as investment credit creation) or to increase the liquidity of the banks (as financial credit creation) or as consumer credit creation (to increase the level of consumer demand) or government-led invention and innovation credit creation (funding R&D and the invention and innovation that leads from that).

Perfect Information Does not Exist Even In Economic Understanding

The second major mistaken neo-classical assumption is that because of perfect information, new economic systems offering better principles of economic organisation will spread immediately throughout the major economies of the world. The financial-industrial innovation of investment credit creation is better than the European investment banking tradition (which is best practised in Germany) and which is better in turn, than the malign neglect of industry and the absence of an industrial policy which is usual in so many Western economies.

The February 2013 “Report from the LSE Growth Commissioners: A Manifesto for Growth” states:

“The modern era of economic growth began around 1800 when a collection of economies initially led by the UK pulled away from the rest. The growth sparked by the industrial revolution was impressive, but what remains remarkable is how few countries emulated the success of the UK and, not long after, France, Germany, Scandinavia and the US. This is because investment requires a supportive climate in which to flourish.”

There is a modern 20th/21st century parallel to that. I would say 

“The 21st century era of explosive economic growth had its origins in the first half of the 20th century, when from 1938 a collection of economies initially led by the USA pulled away from the rest. The very high growth sparked by the financial-industrial system of investment-credit-creation (or Shimomuran economics) was spectacular, but what remains remarkable is how few countries emulated the success of the 1938-44 USA and, not long after, Japan, South Korea, Taiwan and China. This is because investment credit requires a deep understanding of economic forces and a supportive intellectual climate in which to flourish. The credit crunch of 2008 was the precipitating incident which led inexorably to the need for the widespread adoption of Shimomuran economics”, as I believe must now occur. The catching-up of Western economic understanding, which Werner has made more certain, is now inevitable. The remaining question is how long it will take.

The entire package of neoclassical economics is an economic blind alley, a parcel of policies which offers no escape from the unending economic depression of the Western economies.

The Shimomuran Economic Model of Japan is a mathematical model. It is almost certainly more realistic than any you may have previously encountered. That model worked”Š-“Šthat is, the input subsets of the model based on Shimomura’s simple and basic calculations of the capital-output ratios of Japanese industry”Š-“Šand produced better overall economic forecasts (of high economic growth) than even the EPA’s ones.

Finally my work is firmly grounded on an economic history that you seem to know nothing about. I agree with you that economic history is a great teacher and hope the lessons from the rapid rise of the China Sea economies can be quickly learned.

My Viewpoint

You are welcome to continue to admire theoretical economists if you choose, but there are real limits to the extent anyone can admire a set of theoretical understandings that does not produce the goods. If the Washington neo-classical consensus worked, the nations of the Western group, taking the advice of the OECD, the IMF and the World Bank, would be more economically successful than the Tokyo Consensus group. They are aren’t.

Consequences

Unless you and the neo-classical theoretical bandwagon pay more attention to the realistic economics of the China Sea economies, you and it are heading for the economic equivalent of the Challenger disaster. Many of the suffering populations of the West would argue that has already occurred. As Feynman has commented, nature cannot be fooled. The Washington Consensus offers no solutions to our current difficulties, while the current Tokyo Consensus”Š-“Šand the many economic understandings demonstrated in the development of the South Manchurian Railway, FDR’s USA from 1938-44, the Japanese miracle from 1946-75, and the rapid development of the China Sea economies”Š-“Šdoes provide, when properly analysed and adopted, potential solutions to the current Western economic difficulties, and to a rapid economic recovery of the West. Chuck Hagel, the US Defence Secretary, has within the last week or so criticised China’s actions in the South China Sea in a speech to a regional defence forum in Singapore. The Chinese have reacted strongly to that. History suggests that changes in hegemonic power are often associated with major military conflict. I hope the lessons of history are gentler this time for you and everyone than they have been in the past, but there is no guarantee of that. The economic weakness of the West is the natural result of the ineffective Washington Consensus economics that you appear to advocate.
I hope we can all learn a better way forward soon.

Thank you for your useful criticisms”Š-“ŠI hope this reply assists your economic understanding and in future I will try to make my meanings as clear as I can. Please try to think a bit more clearly. I wish you well in your economic education. Please also feel free to criticise me further, when I would hope and expect to benefit further from the experience. I hope this response clears up your misunderstandings and I apologise for its inevitable length. I also hope you find this helpful. I send it to you with my very best regards in the hope that, despite having spent some time at Barclays Bank, you may yet one day soon understand Shimomuran economics. For much more information on this subject see http://www.lulu.com/shop/george-tait-edwards/shimomuran-economics/paperback/product-21688864.html
© George Tait Edwards 2014 

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This post was written by George Tait Edwards