As I said last week, by reading Ghislaine Idabouk's briliant dissertation on the mathematics of options pricing (Black, Scholes, Merton, etc) I have been inspired to do a weekly blog on philosophy of economics. Part of my motivation is my frustration with the endless fascination with Keynes, Friedman, and Hayek in (reasonably intellectual) public discussions and polemics about economics; these polemics do little justice to the character of more contemporary economics.
This week I want to bring together four ironic facts. The story starts with the brilliant, but now largely forgotten Polish economist, Oskar Lange; he was an "ardent socialist," but deplored the Marxian labor theory of value, being very much a believer in the Neoclassical theory of price." Lange (1904-1965) "proposed that central planning boards set prices through "trial and error", making adjustments as shortages and surpluses occurred rather than relying on a free price mechanism. If there were shortages, prices would be raised; if there were surpluses, prices would be lowered. [...] Therefore, it would be a simulation of the market mechanism, which Lange thought would be capable of effectively managing supply and demand." (In many ways Lange is the father of the doctrine now known as neo-Liberalism.) Most government sponsored healthcare and university systems in so-called Liberal Democracies run on Lange-ian principles to this day. This is the first irony. (The second irony is that Lange's "as-if" became identified with the methodology of his ideological opponent, Milton Friedman.)
In 1942 Lange also contributed to core of what came to be known as Arrow-Debreu-McKenzie or General equilibrium model by proving the first two fundamental welfare theorems, which link the concept of a competitive equilibrium with that of a Pareto-optimal allocation. Now as Sonja Amadae showed in her terrific book, Rationalizing capitalist democracy: the Cold War origins of rational choice liberalism (Chicago 2003), the Arrow-Debreu model is the conceptual core of various (including Rawlsian) justificatory and normative approaches to the social institutions of liberal democracies. But, peculiarly, this edifice does not contain money! (I am not the first to recognize this, of course. Lange's brilliant student, Don Patenkin, and Frank Hahn both became famous for attempts at integrating money into the model.) The third irony, which I first appreciated by reading a draft of a terrific review article by Ali M. Khan, is that modern capitalism was modelled without money.
Now in later installments I will reflect more on the significance of the absence of money for contemporary economists' lack of inability to ask the right questions about (asset price) bubbles. But here I want to close by returning to Ibadouk's dissertation. As she notes Black, Scholes, and Merton drop talk of supply and demand (they deploy the no-arbitrage assumption [about which more in later weeks] inherited from General Equilibrium theory instead). While the formula was much refined and improved in subsequent decades, no-arbitrage is bedrock to options pricing. What Black, Scholes, and Merton achieved was to create a formula that allowed the very possibility to calculate "rational" prices for options (and other financial instruments). (The key ingredient that needed to be plugged into the formula is some measure of volatility of the underlying stock--historical data that Black went on to sell to options traders.) Black, Scholes, Merton is a normative formula that as Donald MacKenzie and Ibadouk have argued is also constitutive (only in part) of the financial markets it is meant to model. That is to say, Scholes and Merton went on to win a Nobel prize (Black had died) for a mathematical technique that presupposed no supply, no demand, and no money. Let's call this fourth, a Lange-ian irony!
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